UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

R QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2011.

OR

£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to __________.

Commission file number: 0-24611

CFS Bancorp, Inc.

(Exact name of registrant as specified in its charter)

Indiana	35-2042093
(State or other jurisdiction	(I.R.S. Employer
of incorporation or organization)	Identification No.)
707 Ridge Road, Munster, Indiana	46321
(Address of principal executive offices)	(Zip code)
(219) 836-2960
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES R                      NO £

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES R                      NO £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer £	Accelerated filer £
Non-accelerated filer £ (Do not check if a smaller reporting company)	Smaller reporting company R

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES £  NO R

The Registrant had 10,875,565 shares of Common Stock issued and outstanding as of October 31, 2011.

CFS BANCORP, INC.

Form 10-Q

TABLE OF CONTENTS

		Page
	PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Statements of Condition	3
	Condensed Consolidated Statements of Income	4
	Condensed Consolidated Statements of Changes in Shareholders’ Equity	5
	Condensed Consolidated Statements of Cash Flows	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	36
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	64
Item 4.	Controls and Procedures	66
	PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	67
Item 1A.	Risk Factors	67
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	67
Item 3.	Defaults Upon Senior Securities	67
Item 4.	(Removed and Reserved)	67
Item 5.	Other Information	68
Item 6.	Exhibits	68
Signature Page		69
Certifications of Principal Executive Officer and Principal Financial Officer
	Exhibit 31.1
	Exhibit 31.2
	Exhibit 32.0

2

CFS BANCORP, INC.

Condensed Consolidated Statements of Condition

	September 30,  2011			December 31,  2010
	(Unaudited)
ASSETS	(Dollars in thousands)
Cash and amounts due from depository institutions	$	33,421		$	24,624
Interest-bearing deposits		84,344			37,130
Cash and cash equivalents		117,765			61,754
Investment securities available-for-sale, at fair value		218,417			197,101
Investment securities held-to-maturity, at cost		14,387			17,201
Federal Home Loan Bank stock, at cost		8,638			20,282
Loans receivable		725,467			732,584
Allowance for loan losses		(17,186	)		(17,179	)
Net loans		708,281			715,405
Loans held for sale		839			—
Bank-owned life insurance		36,095			35,463
Accrued interest receivable		2,908			3,162
Other real estate owned		17,195			22,324
Office properties and equipment		18,053			20,464
Net deferred tax assets		17,708			17,923
Other assets		8,195			10,597
Total assets	$	1,168,481		$	1,121,676
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits	$	986,441		$	945,884
Borrowed funds		56,115			53,550
Advance payments by borrowers for taxes and insurance		5,868			4,618
Other liabilities		5,302			4,696
Total liabilities		1,053,726			1,008,748
Commitments and contingencies
Shareholders’ equity:
Preferred stock, $.01 par value; 15,000,000 shares authorized		—			—
Common stock, $.01 par value; 85,000,000 shares authorized; 23,423,306 shares issued; 10,877,015 and 10,850,040 shares outstanding		234			234
Additional paid-in capital		187,023			187,164
Retained earnings		85,365			83,592
Treasury stock, at cost; 12,546,291 and 12,573,266 shares		(154,766	)		(155,112	)
Accumulated other comprehensive loss, net of tax		(3,101	)		(2,950	)
Total shareholders’ equity		114,755			112,928
Total liabilities and shareholders’ equity	$	1,168,481		$	1,121,676

See accompanying notes to the unaudited condensed consolidated financial statements.

3

CFS BANCORP, INC.

Condensed Consolidated Statements of Income

	Three Months Ended September 30,					Nine Months Ended September 30,
	2011			2010		2011		2010
	(Unaudited)
	(Dollars in thousands, except share and per share data)
Interest income:
Loans receivable	$	8,881		$	9,199	$	26,708	$	28,503
Investment securities		1,794			2,176		5,879		6,552
Other interest-earning assets		80			90		401		337
Total interest income		10,755			11,465		32,988		35,392
Interest expense:
Deposits		1,602			2,143		5,272		6,342
Borrowed funds		294			436		813		1,392
Total interest expense		1,896			2,579		6,085		7,734
Net interest income		8,859			8,886		26,903		27,658
Provision for loan losses		2,673			525		4,572		3,052
Net interest income after provision for loan losses		6,186			8,361		22,331		24,606
Non-interest income:
Service charges and other fees		1,263			1,290		3,513		3,830
Card-based fees		520			475		1,515		1,398
Commission income		100			40		223		140
Net gain on sale of:
Investment securities		758			―		1,450		456
Loans held for sale		66			―		124		―
Other real estate owned		266			2		2,499		14
Income from bank-owned life insurance		216			217		632		702
Other income		121			103		343		371
Total non-interest income		3,310			2,127		10,299		6,911
Non-interest expense:
Compensation and employee benefits		4,818			4,709		15,104		13,928
Net occupancy expense		706			691		2,141		2,097
FDIC insurance premiums and regulatory assessments		481			623		1,638		1,891
Professional fees		309			512		1,031		1,850
Furniture and equipment expense		436			488		1,353		1,547
Data processing		424			443		1,307		1,316
Marketing		213			189		670		519
Other real estate owned related expense, net		614			470		3,217		1,356
Loan collection expense		117			156		470		478
Severance and early retirement expense		―			88		―		528
Other general and administrative expenses		1,068			1,068		3,293		2,990
Total non-interest expense		9,186			9,437		30,224		28,500
Income before income taxes		310			1,051		2,406		3,017
Income tax (benefit) expense		(84	)		188		307		475
Net income	$	394		$	863	$	2,099	$	2,542
Per share data:
Basic earnings per share	$	.04		$	.08	$	.20	$	.24
Diluted earnings per share		.04			.08		.20		.24
Cash dividends declared per share		.01			.01		.03		.03
Weighted-average common and common share      equivalents outstanding:
Basic		10,693,724			10,657,719		10,678,788		10,626,890
Diluted		10,753,386			10,707,163		10,739,969		10,701,072

See accompanying notes to the unaudited condensed consolidated financial statements.

4

CFS BANCORP, INC.

Condensed Consolidated Statements of Changes in Shareholders’ Equity

												Accumulated
			Additional									Other
	Common		Paid-In			Retained			Treasury			Comprehensive
	Stock		Capital			Earnings			Stock			Loss			Total
	(Unaudited)
	(Dollars in thousands)
Balance at January 1, 2010	$	234	$	188,930		$	80,564		$	(157,041	)	$	(2,314	)	$	110,373
Net income		—		—			2,542			—			—			2,542
Other comprehensive income:
Change in unrealized depreciation on investment securities available-for-sale, net of reclassification and tax		—		—			—			—			1,124			1,124
Total comprehensive income		—		—			—			—			—			3,666
Net distribution of Rabbi Trust shares		—		(447	)		—			447			—			—
Forfeiture of restricted stock awards		—		295			4			(295	)		—			4
Vesting of restricted stock awards		—		164			—			—			—			164
Unearned compensation restricted stock awards		—		(436	)		—			436			—			—
Reclassification of treasury stock issuances of restricted stock at average cost		—		(1,431	)		—			1,431			—			—
Dividends declared on common stock ($.03 per share)		—		—			(327	)		—			—			(327	)
Balance at September 30, 2010	$	234	$	187,075		$	82,783		$	(155,022	)	$	(1,190	)	$	113,880
Balance at January 1, 2011	$	234	$	187,164		$	83,592		$	(155,112	)	$	(2,950	)	$	112,928
Net income		—		—			2,099			—			—			2,099
Other comprehensive income:
Change in unrealized depreciation on investment securities available-for-sale, net of reclassification and tax		—		—			—			—			(151	)		(151	)
Total comprehensive income		—		—			—			—			—			1,948
Net distribution of Rabbi Trust shares		—		(119	)		—			119			—			—
Forfeiture of restricted stock awards		—		445			2			(445	)		—			2
Vesting of restricted stock awards		—		205			—			—			—			205
Unearned compensation restricted stock awards		—		(672	)		—			672			—			—
Dividends declared on common stock ($.03 per share)		—		—			(328	)		—			—			(328	)
Balance at September 30, 2011	$	234	$	187,023		$	85,365		$	(154,766	)	$	(3,101	)	$	114,755

See accompanying notes to the unaudited condensed consolidated financial statements.

5

CFS BANCORP, INC.

Condensed Consolidated Statements of Cash Flows

	Nine Months Ended
	September 30,
	2011			2010
	(Unaudited)
	(Dollars in thousands)
OPERATING ACTIVITIES:
Net income	$	2,099		$	2,542
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		4,572			3,052
Depreciation and amortization		1,121			1,200
Net discount accretion on investment securities available-for-sale		(7	)		(406	)
Net premium amortization on investment securities held-to-maturity		120			125
Net gain on sale of:
Loans held for sale		(124	)		—
Investment securities		(1,450	)		(456	)
Other real estate owned		(2,499	)		(14	)
Write downs on other real estate owned		2,101			642
Write downs on transfer of future branch sites to other real estate owned		396			—
Write down on construction in process		106			—
Deferred income tax expense		408			386
Proceeds from sale of loans held for sale		5,680			—
Origination of loans held for sale		(6,139	)		(4,144	)
Increase in cash surrender value of bank-owned life insurance		(632	)		(702	)
Decrease in other assets		2,875			1,694
Increase in other liabilities		375			521
Net cash flows provided by operating activities		9,002			4,440
INVESTING ACTIVITIES:
Proceeds from sale of:
Investment securities, available-for-sale		42,136			9,603
Loan participations		2,088			—
Other real estate owned		13,409			1,144
Proceeds from maturities and pay downs of:
Investment securities, available-for-sale		39,127			61,744
Investment securities, held-to-maturity		2,694			1,500
Purchases of:
Investment securities, available-for-sale		(101,336	)		(90,724	)
Investment securities, held-to-maturity		—			(8,456	)
Properties and equipment		(323	)		(1,429	)
Redemption of Federal Home Loan Bank stock		11,645			—
Net change in loans		(6,397	)		16,262
Net cash flows provided by (used in) investing activities		3,043			(10,356	)
FINANCING ACTIVITIES:
Net increase (decrease) in:
Deposit accounts		40,478			80,012
Advance payments by borrowers for taxes and insurance		1,250			1,630
Short-term borrowed funds		2,824			(10,367	)
Proceeds from Federal Home Loan Bank advances		15,000			18,000
Repayments of Federal Home Loan Bank advances		(15,259	)		(55,242	)
Dividends paid on common stock		(327	)		(327	)
Net cash flows provided by financing activities		43,966			33,706
Increase in cash and cash equivalents		56,011			27,790
Cash and cash equivalents at beginning of period		61,754			24,428
Cash and cash equivalents at end of period	$	117,765		$	52,218
Supplemental disclosures:
Loans and land transferred to other real estate owned	$	7,881		$	16,741
Cash paid for interest on deposits		5,279			6,344
Cash paid for interest on borrowed funds		834			1,425
Cash paid for income taxes		—			1,075

See accompanying notes to the unaudited condensed consolidated financial statements.

6

CFS BANCORP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information or footnotes necessary for a complete presentation of financial condition, results of operations, or cash flows in accordance with U.S. generally accepted accounting principles.  In our opinion, all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation have been included.  The results of operations for the three and nine months ended September 30, 2011 are not necessarily indicative of the results expected for the year ending December 31, 2011.  The September 30, 2011 condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes for the year ended December 31, 2010 included in the Company’s Annual Report on Form 10-K.

The preparation of the condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates, judgments, or assumptions that could have a material effect on the carrying value of certain assets and liabilities.  These estimates, judgments, and assumptions affect the amounts reported in the condensed consolidated financial statements and the disclosures provided.  The determination of the allowance for loan losses, valuations and impairments of investment securities, and the accounting for income tax expense are highly dependent on management’s estimates, judgments, and assumptions where changes in any of these could have a significant impact on the financial statements.

The condensed consolidated financial statements include the accounts of CFS Bancorp, Inc. (the Company), its wholly-owned subsidiary, Citizens Financial Bank (the Bank), and its wholly-owned subsidiaries, CFS Holdings, LTD and WHCC, LLC.  All material intercompany balances and transactions have been eliminated in consolidation.

Certain items in the condensed consolidated financial statements of prior periods have been reclassified to conform to the current period’s presentation.

2. Earnings Per Share

Basic earnings per common share (EPS) is computed by dividing net income by the weighted-average number of common shares outstanding during the year.  Restricted stock shares which have not vested and shares held in Rabbi Trust accounts are not considered to be outstanding for purposes of calculating basic EPS.  Diluted EPS is computed by dividing net income by the average number of common shares outstanding during the year and includes the dilutive effect of stock options, unearned restricted stock awards, and treasury shares held in Rabbi Trust accounts pursuant to deferred compensation plans.  The dilutive common stock equivalents are computed based on the treasury stock method using the average market price for the period.

7

The following table sets forth the computation of basic and diluted earnings per share:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
	(Dollars in thousands, except per share data)
Net income	$	394	$	863	$	2,099	$	2,542
Weighted-average common shares:
Outstanding		10,693,724		10,657,719		10,678,788		10,626,890
Equivalents (1)		59,662		49,444		61,181		74,182
Total		10,753,386		10,707,163		10,739,969		10,701,072
Earnings per share:
Basic	$	.04	$	.08	$	.20	$	.24
Diluted		.04		.08		.20		.24
Number of anti-dilutive stock options excluded from the diluted earnings per share calculation		516,495		651,995		559,847		681,336
Weighted-average exercise price of anti-dilutive option shares	$	14.03	$	13.44	$	13.81	$	13.37

____________________

(1) Assumes exercise of dilutive stock options, a portion of the unearned restricted stock awards, and treasury shares held in Rabbi Trust accounts.

3.   Investment Securities

The amortized cost of investment securities and their fair values are as follows for the periods indicated:

					Gross		Gross
	Par		Amortized		Unrealized		Unrealized			Fair
	Value		Cost		Gains		Losses			Value
	(Dollars in thousands)
At September 30, 2011:
Available-for-sale investment securities:
U.S. Treasury securities	$	15,000	$	14,969	$	436	$	—		$	15,405
Government sponsored entity (GSE) securities		51,800		51,923		1,665		—			53,588
Corporate bonds		4,000		3,677		66		—			3,743
Collateralized mortgage obligations		56,825		50,978		1,258		(1,088	)		51,148
Commercial mortgage-backed securities		74,892		76,646		1,114		(236	)		77,524
Pooled trust preferred securities		27,910		25,220		—		(8,215	)		17,005
GSE preferred stock		200		—		4		—			4
Total available-for-sale securities	$	230,627	$	223,413	$	4,543	$	(9,539	)	$	218,417
Held-to-maturity investment securities:
Asset backed securities	$	8,620	$	8,917	$	244	$	—		$	9,161
Municipal securities		5,470		5,470		63		—			5,533
Total held-to-maturity investment securities	$	14,090	$	14,387	$	307	$	—		$	14,694

8

					Gross		Gross
	Par		Amortized		Unrealized		Unrealized			Fair
	Value		Cost		Gains		Losses			Value
	(Dollars in thousands)
At December 31, 2010:
Available-for-sale investment securities:
U.S. Treasury securities	$	15,000	$	14,975	$	3	$	(159	)	$	14,819
Government sponsored entity (GSE) securities		30,800		30,717		421		(118	)		31,020
Corporate bonds		4,000		3,629		—		(43	)		3,586
Collateralized mortgage obligations		62,512		59,037		2,071		(353	)		60,755
Commercial mortgage-backed securities		66,282		67,052		1,804		(158	)		68,698
Pooled trust preferred securities		29,409		26,473		—		(8,348	)		18,125
GSE preferred stock		5,837		—		98		—			98
Total available-for-sale securities	$	213,840	$	201,883	$	4,397	$	(9,179	)	$	197,101
Held-to-maturity investment securities:
Asset backed securities	$	9,844	$	10,261	$	126	$	(7	)	$	10,380
Municipal securities		6,940		6,940		106		—			7,046
Total held-to-maturity investment securities	$	16,784	$	17,201	$	232	$	(7	)	$	17,426

The Company’s investments in collateralized mortgage obligations consisted of $5.5 million and $13.5 million of GSE issued investment securities and $45.6 million and $47.3 million of non-agency (private issued) residential investment securities at September 30, 2011 and December 31, 2010, respectively.

Investment securities with unrealized losses aggregated by investment category and length of time that individual investment securities have been in a continuous unrealized loss position are presented in the following tables for the dates indicated.

	September 30, 2011
	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses
	(Dollars in thousands)
Collateralized mortgage obligations	$	21,734	$	(1,077	)	$	38	$	(11	)	$	21,772	$	(1,088	)
Commercial mortgage-backed securities		20,847		(236	)		—		—			20,847		(236	)
Pooled trust preferred securities		—		—			17,005		(8,215	)		17,005		(8,215	)
	$	42,581	$	(1,313	)	$	17,043	$	(8,226	)	$	59,624	$	(9,539	)

	December 31, 2010
	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses
	(Dollars in thousands)
U.S. Treasury securities	$	11,905	$	(159	)	$	—	$	—		$	11,905	$	(159	)
GSE securities		5,870		(118	)		—		—			5,870		(118	)
Corporate bonds		3,586		(43	)		—		—			3,586		(43	)
Collateralized mortgage obligations		8,538		(323	)		1,204		(30	)		9,742		(353	)
Commercial mortgage-backed securities		10,255		(158	)		—		—			10,255		(158	)
Pooled trust preferred securities		—		—			18,125		(8,348	)		18,125		(8,348	)
Asset backed securities		10,380		(7	)		—		—			10,380		(7	)
	$	50,534	$	(808	)	$	19,329	$	(8,378	)	$	69,863	$	(9,186	)

9

We evaluate all investment securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if an other-than-temporary impairment (OTTI) exists pursuant to guidelines established in the Financial Accounting Standards Board Accounting Standards Codification (ASC) 320-10, Investments – Debt and Equity Securities.  Current accounting guidance generally provides that if a marketable security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the investment securities must assess whether the impairment is other-than-temporary.

In management’s belief, the decline in value of the Company’s investment in collateralized mortgage obligations is minimal and primarily attributable to changes in market interest rates and macroeconomic conditions affecting liquidity and not necessarily the expected cash flows of the individual investment securities.  The fair value of these investment securities is expected to recover as macroeconomic conditions improve, interest rates rise, and the investment securities approach their maturity date.

At September 30, 2011, the Company’s pooled trust preferred investment securities consisted of “Super Senior” securities backed by senior securities issued mainly by bank and thrift holding companies.  Due to the structure of the securities, as deferrals and defaults on the underlying collateral increase, cash flows are increasingly diverted from mezzanine and subordinate tranches to pay down principal on the “Super Senior” tranches.  In management’s belief, the decline in value is primarily attributable to macroeconomic conditions affecting liquidity of these securities and not necessarily the expected cash flows of the individual securities. The fair value of these securities is expected to recover as the securities approach their maturity date.

Unrealized losses on collateralized mortgage obligations and pooled trust preferred investment securities have not been recognized in income because management does not have the intent to sell these securities and has the ability to hold these securities for a period of time sufficient to allow for any anticipated recovery in fair value, which may be at maturity.  We may, from time to time, dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds could be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.  The Company concluded that the unrealized losses that existed at September 30, 2011 did not constitute other-than-temporary impairments.

The amortized cost and fair value of investment securities at September 30, 2011, by contractual maturity, are shown in the following tables.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.  Investment securities not due at a single maturity date are shown separately.

10

	Available-for-Sale
	Amortized		Fair
	Cost		Value
	(Dollars in thousands)
U.S. Treasury securities:
Due in one year or less	$	3,005	$	3,008
Due after one year through five years		11,964		12,397
GSE securities:
Due in one year or less		798		831
Due after one year through five years		51,125		52,757
Corporate bonds — Due after five years		3,677		3,743
Collateralized mortgage obligations:
Due after one year through five years		737		741
Due after five years		50,241		50,407
Commercial mortgage-backed securities		76,646		77,524
Pooled trust preferred securities		25,220		17,005
GSE preferred stock		—		4
	$	223,413	$	218,417

	Held-to-Maturity
	Amortized		Fair
	Cost		Value
	(Dollars in thousands)
Asset backed securities — Due after five years	$	8,917	$	9,161
Municipal securities:
Due in one year or less		2,500		2,518
Due after one year through five years		2,970		3,015
	$	14,387	$	14,694

The following table provides information as to the amount of gross gains and losses realized through the sales of investment securities available-for-sale:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2011		2010		2011		2010
	(Dollars in thousands)
Available-for-sale securities:
Gross realized gains	$	758	$	—	$	1,450	$	456
Gross realized losses		—		—		—		—
Net realized gains	$	758	$	—	$	1,450	$	456
Income tax expense on realized gains	$	272	$	—	$	525	$	155

The carrying value of investment securities pledged as collateral to secure public deposits and for other purposes at September 30, 2011 and December 31, 2010 was $54.5 million and $47.9 million, respectively.  Other than the U.S. Government, its agencies, and GSEs, there were no other holdings of investment securities of any one issuer in an amount greater than 10% of shareholders’ equity.

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4.   Loans Receivable

Loans receivable are summarized as follows:

	September 30, 2011			December 31, 2010
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	83,569		$	74,940
Commercial real estate:
Owner occupied		100,244			99,435
Non-owner occupied		193,267			191,998
Multifamily		70,129			72,080
Commercial construction and land development		22,635			24,310
Commercial participations		16,739			23,594
Total commercial loans		486,583			486,357
Retail loans:
One-to-four family residential		181,025			185,321
Home equity lines of credit		53,953			56,177
Retail construction		1,299			3,176
Other		3,007			2,122
Total retail loans		239,284			246,796
Total loans receivable		725,867			733,153
Net deferred loan fees		(400	)		(569	)
Total loans receivable, net of deferred loan fees	$	725,467		$	732,584

5.   Allowance for Loan Losses

The Company maintains an allowance for loan losses at a level management believes is appropriate in relation to the estimated risk inherent in the loan portfolio.  The allowance for loan losses represents the Company’s estimate of probable incurred losses in our loan portfolio at each statement of condition date and is based on the review of available and relevant information.

The first component of the allowance for loan losses contains allocations for probable incurred losses that we have identified relating to impaired loans pursuant to ASC 310-10, Receivables.  The Company individually evaluates for impairment all loans classified substandard and over $750,000.  For all portfolio segments, loans are considered impaired when, based on current information and events, it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement.  The impairment loss, if any, is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate.  As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral-dependent.  A loan is considered collateral-dependent when the repayment of the loan will be provided solely by the underlying collateral and there are no other available and reliable sources of repayment.  If management determines a loan is collateral-dependent, management will charge-off any identified collateral shortfall against the allowance for loan losses.

If foreclosure is probable, the Company is required to measure the impairment based on the fair value of the collateral.  The fair value of the collateral is generally obtained from appraisals or estimated using an appraisal-like methodology.  When current appraisals are not available, management estimates the fair value of the collateral giving consideration to several factors including the price at which individual unit(s) could be sold in the current market, the period of time over which the unit(s) could be sold, the estimated cost to complete the

12

unit(s), the risks associated with completing and selling the unit(s), the required return on the investment a potential acquirer may have, and the current market interest rates.  The analysis of each loan involves a high degree of judgment in estimating the amount of the loss associated with the loan, including the estimation of the amount and timing of future cash flows and collateral values.

The second component of the Company’s allowance for loan losses contains allocations for probable incurred losses within various pools of loans with similar characteristics pursuant to ASC 450-10, Contingencies.  This component is based in part on certain loss factors applied to various stratified loan pools excluding loans evaluated individually for impairment.  In determining the appropriate loss factors for all portfolio segments, management considers historical charge-offs and recoveries; levels of and trends in delinquencies, impaired loans, and other classified loans; concentrations of credit within the commercial loan portfolios; volume and type of lending; and current and anticipated economic conditions.

Loan losses for all portfolio segments are charged-off against the allowance when the loan balance or a portion of the loan balance is no longer covered by the paying capacity of the borrower based on an evaluation of available cash resources and collateral value, while recoveries of amounts previously charged-off are credited to the allowance.  The Company assesses the appropriateness of the allowance for loan losses on a quarterly basis and adjusts the allowance for loan losses by recording a provision for loan losses in an amount sufficient to maintain the allowance at a level deemed appropriate by management.  The evaluation of the appropriateness of the allowance for loan losses is inherently subjective as it requires estimates that are susceptible to significant revision as additional information becomes available or as future events occur.  To the extent that actual outcomes differ from management’s estimates, an additional provision for loan losses could be required which could adversely affect earnings or the Company’s financial position in future periods.

Prior to December 31, 2010, the allowance was calculated using a static four year historical net charge-off factor for each regulatory reporting loan category without segregation of purchased participation loans.  At December 31, 2010, management determined that a rolling eight quarter loss history ending with the current quarter was more indicative of the current inherent losses in the loan portfolio at December 31, 2010 and more consistent with trends in the banking industry.  In addition, the purchased participation loans were segregated as a separate loan category.  These changes in the allowance methodology resulted in a reduction in the historical loss factor percentages applied to most of the directly originated loan portfolio categories and a larger historical loss factor percentage applied to the purchased participation portfolio.  The net effect of these changes was a decrease in the provision and the allowance for loan losses at December 31, 2010 of $1.2 million.  The effect of the change in the methodology on the provision for loan losses for the three and nine months ended September 30, 2011 from the three and nine months ended September 30, 2010 was deemed to be immaterial.

The risk characteristics of each loan portfolio segment are as follows:

Commercial and Industrial Loans (C&I)

C&I loans are primarily based on the identified historic and/or the projected cash flows of the borrower and secondarily on the underlying collateral provided by the borrower.  The cash flows of borrowers, however, do fluctuate based on changes in the company’s internal and external environment including management, human and capital resources, economic conditions, competition, regulation, and product innovation/obsolescence.  The collateral securing these loans may also fluctuate in value and generally has advance rates between 50-80% of the collateral value.  Most C&I loans are secured by business assets being financed such as equipment, accounts receivable, and/or inventory and generally incorporate a secured or unsecured personal guarantee.  Occasionally, some short-term loans may be made on an unsecured basis.  In the

13

case of loans secured by accounts receivable and/or inventory, the collateral securing the advances is generally monitored through a Borrowing Base Certificate submitted by the borrower which may identify deterioration in collateral value.  The ability of the borrower to collect amounts due from its customers may be affected by its customers’ economic and financial condition.  The availability of funds for the repayment of these loans may be substantially dependent on each of the factors described above.

Commercial Real Estate – Owner Occupied, Non-Owner Occupied, and Multifamily

These types of commercial real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate.  Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent upon the cash flows from the successful operation of the property securing the loan or the cash flows from the owner occupied business conducted on the property securing the loan.  A borrower’s business and/or the property securing the loan may be adversely affected by business conditions generally, and fluctuations in the real estate markets or in the general economy, which if adverse, can negatively affect the borrowers’ ability to repay the loan.  The value and cash flow of the property can be influenced by changes in market rental rates, changes in interest rates or investors’ required rates of return, the condition of the property, zoning, or environmental issues.  The properties securing the commercial real estate portfolio are diverse in terms of type and are generally located in the Chicagoland/Northwest Indiana market.  Owner occupied loans are generally a borrower purchased building where the borrower occupies at least 50% of the space with the primary source of repayment dependent on sources other than the underlying collateral.  Non-owner occupied and single tenant properties may have higher risk than owner occupied loans since the primary source of repayment is dependent upon the ability to lease out the collateral as well as the financial stability of the businesses occupying the collateral.  Multifamily loans can also be impacted by vacancy/collection losses and tenant turnover due to generally shorter term leases or even month-to-month leases.  Management monitors and evaluates commercial real estate loan portfolio concentrations based upon cash flow, collateral, geography, and risk grade criteria.  As a general rule, management avoids financing single purpose projects unless other underwriting factors mitigate the credit risk to an acceptable level.  The Company’s loan policy generally requires lower loan-to-value ratios against these types of properties.

Commercial Construction and Land Development Loans

Construction loans are underwritten utilizing feasibility studies, independent appraisals, sensitivity analysis of absorption and lease rates, presale or prelease/Letters of Intent analysis, and financial analysis of the developers and property owners.  Construction loans are generally based on the estimated cost to construct and cash flows associated with the completed project or stabilized value.  These estimates are subjective in nature and if erroneous, may preclude the borrower from being able to repay the loan.  Construction loans often involve the disbursement of substantial funds with repayment dependent on the success of the completed project.  These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions, the ability to sell the property, and the availability of long-term financing.

Commercial Participation Loans

Participation loans generally have larger principal balances, portions of which are sold to multiple participant banks in order to spread credit risk.  The collateral securing these loans is often real estate and is often located outside of the Company’s geographic footprint.  Loans outside of the Company’s geographical footprint pose additional risk due to the lack of knowledge of general economic conditions where the project is

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located along with various project specific risks regarding buyer demand and project specific risks regarding project competition risks.  The participant banks are required to underwrite these credits utilizing their own internal analysis techniques and to their own credit standards.  However, the participant banks are reliant upon the information about the borrowers and the collateral provided by the lead bank.  These loans carry higher levels of risk due to the participant banks being dependent on the lead bank for monitoring and managing the credit relationship, including the workout and/or foreclosure process should the borrower default.

Retail Loans

The Company’s retail loans include one-to-four family residential mortgage loans, home equity loans and lines of credit, retail construction, and other consumer loans.  Management has established a maximum loan-to-value ratio (LTV) of 80% for one-to-four family residential mortgages and home equity loans and lines of credit that are secured by a first or second mortgage on owner and non-owner occupied residences.  Loan applications exceeding 80% LTV require private mortgage insurance (PMI) from a mortgage insurance company deemed acceptable by management.  Residential construction loans are underwritten to the same standards and generally require an end loan financing commitment either from the Company or another financial institution acceptable to the Company.  Other consumer loans are generally small dollar auto and personal loans based on the credit score and income of the applicant.  These loans are very homogenous in nature and are rated in pools based on similar characteristics.

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The following tables present the activity in the allowance for loan losses for the three and nine months ended September 30, 2011 and the balance in the allowance for loan losses and loan balances by portfolio segment and impairment method at September 30, 2011 and December 31, 2010.

	Commercial			Commercial Real Estate									Construction						One-to-four
	and			Owner			Non-Owner						and Land			Commercial			Family						Retail
	Industrial			Occupied			Occupied			Multifamily			Development			Participations			Residential			HELOC			Construction			Other			Total
	(Dollars in thousands)
Allowance for loan losses:
Balance at June 30, 2011	$	1,554		$	829		$	6,515		$	441		$	93		$	4,787		$	1,387		$	1,284		$	5		$	144		$	17,039
Provision for loan losses		717			1,519			502			135			(17	)		(117	)		154			(246	)		(1	)		27			2,673
Loans charged-off		(532	)		(875	)		(448	)		(109	)		—			(89	)		(113	)		(360	)		—			(30	)		(2,556	)
Recoveries		4			4			10			1			—			—			4			1			—			6			30
Balance at September 30, 2011	$	1,743		$	1,477		$	6,579		$	468		$	76		$	4,581		$	1,432		$	679		$	4		$	147		$	17,186
Allowance for loan losses:
Balance at December 31, 2010	$	1,279		$	1,090		$	6,906		$	350		$	188		$	4,559		$	1,356		$	1,309		$	7		$	135		$	17,179
Provision for loan losses		1,139			1,383			97			430			(108	)		1,419			373			(225	)		(3	)		67			4,572
Loans charged-off		(685	)		(1,000	)		(448	)		(313	)		(4	)		(1,397	)		(304	)		(412	)		—			(80	)		(4,643	)
Recoveries		10			4			24			1			—			—			7			7			—			25			78
Balance at September 30, 2011	$	1,743		$	1,477		$	6,579		$	468		$	76		$	4,581		$	1,432		$	679		$	4		$	147		$	17,186
Ending allowance balance:
Individually evaluated     for impairment	$	—		$	398		$	4,667		$	—		$	—		$	3,593		$	—		$	—		$	—		$	—		$	8,658
Collectively evaluated     for impairment		1,743			1,079			1,912			468			76			988			1,432			679			4			147			8,528
Total evaluated for     impairment at     September 30, 2011	$	1,743		$	1,477		$	6,579		$	468		$	76		$	4,581		$	1,432		$	679		$	4		$	147		$	17,186
Loans receivable:
Individually evaluated     for impairment	$	2,902		$	13,736		$	28,899		$	675		$	7,171		$	6,442		$	—		$	—		$	—		$	—		$	59,825
Collectively evaluated     for impairment		80,667			86,508			164,368			69,454			15,464			10,297			181,025			53,953			1,299			3,007			666,042
Balance at September 30, 2011	$	83,569		$	100,244		$	193,267		$	70,129		$	22,635		$	16,739		$	181,025		$	53,953		$	1,299		$	3,007		$	725,867

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	Commercial		Commercial Real Estate						Construction				One-to-four
	and		Owner		Non-Owner				and Land		Commercial		Family				Retail
	Industrial		Occupied		Occupied		Multifamily		Development		Participations		Residential		HELOC		Construction		Other		Total
	(Dollars in thousands)
Allowance for loan losses:
Balance at December 31, 2010	$	1,279	$	1,090	$	6,906	$	350	$	188	$	4,559	$	1,356	$	1,309	$	7	$	135	$	17,179
Ending allowance balance:
Individually evaluated     for impairment	$	—	$	433	$	4,492	$	—	$	—	$	3,497	$	—	$	—	$	—	$	—	$	8,422
Collectively evaluated     for impairment		1,279		657		2,414		350		188		1,062		1,356		1,309		7		135		8,757
Total evaluated for     impairment at     December 31, 2010	$	1,279	$	1,090	$	6,906	$	350	$	188	$	4,559	$	1,356	$	1,309	$	7	$	135	$	17,179
Loans receivable:
Individually evaluated     for impairment	$	3,692	$	11,135	$	21,218	$	264	$	9,183	$	9,499	$	—	$	—	$	—	$	—	$	54,991
Collectively evaluated     for impairment		71,248		88,300		170,780		71,816		15,127		14,095		185,321		56,177		3,176		2,122		678,162
Balance at December 31, 2010	$	74,940	$	99,435	$	191,998	$	72,080	$	24,310	$	23,594	$	185,321	$	56,177	$	3,176	$	2,122	$	733,153

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The Company, as a matter of good risk management practices, utilizes objective loan grading matrices to assign risk ratings to all commercial loans.  The risk rating criteria is clearly supported by core credit attributes that emphasize debt service coverage, operating trends, collateral, and guarantor liquidity, and further removes subjective criteria and bias from the analysis.  Retail loans are rated pass until they become 90 days or more delinquent, put on non-accrual status, and generally rated substandard.  The Company uses the following definitions for risk ratings:

● Pass.  Loans that meet the conservative underwriting guidelines that include core credit attributes noted above as measured by the loan grading matrices at levels that are in excess of the minimum amounts required to adequately service the loans.

● Pass Watch.  Loans which are performing per their contractual terms and are not necessarily demonstrating signs of credit or operational weakness, including but not limited to delinquency.  Loans in this category are monitored by management for timely payments.  Current financial information may be pending or, based upon the most recent analysis of the loan, possess credit attributes that are sufficient to adequately service the loan, but are less than the parameters required for a pass risk rating.  This rating is considered transitional because management does not have current financial information to determine the appropriate risk grade or the quality of the loan appears to be changing.  Loans may be graded as pass watch when a single event may have occurred that could be indicative of an emerging issue or indicate trending that would warrant a change in the risk rating.

● Special Mention.  Loans that have a potential weakness that will be closely monitored by management.  A credit graded special mention does not expose the Company to elevated risk that would warrant an adverse classification.

● Substandard.  Loans that are inadequately protected by the current net worth and paying capacity of the borrower, guarantor, or the collateral pledged.  Loans classified as substandard have a well-defined weakness or weaknesses, characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

● Doubtful.  Loans that have the same weaknesses as those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

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The Company’s loans receivable portfolio is summarized by risk rating category as follows:

	Risk Rating at September 30, 2011
					Special
	Pass		Pass Watch		Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	70,625	$	11,414	$	953	$	571	$	6	$	83,569
Commercial real estate:
Owner occupied		69,728		15,184		1,175		14,157		—		100,244
Non-owner occupied		147,777		10,765		7,302		27,423		—		193,267
Multifamily		64,123		3,077		1,731		1,198		—		70,129
Commercial construction and           land development		12,607		871		1,450		7,707		—		22,635
Commercial participations		10,297		—		—		6,442		—		16,739
Total commercial loans		375,157		41,311		12,611		57,498		6		486,583
Retail loans:
One-to-four family residential		176,088		—		—		4,937		—		181,025
Home equity lines of credit		53,158		—		—		795		—		53,953
Retail construction		1,130		—		—		169		—		1,299
Other		3,007		—		—		—		—		3,007
Total retail loans		233,383		—		—		5,901		—		239,284
Total loans	$	608,540	$	41,311	$	12,611	$	63,399	$	6	$	725,867

					Special
	Pass		Pass Watch		Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Current	$	603,794	$	39,802	$	10,058	$	12,210	$	—	$	665,864
Delinquent:
30-59 days		3,564		1,419		649		10,217		6		15,855
60-89 days		1,092		90		1,904		928		—		4,014
90 days or more		90		—		—		40,044		—		40,134
Total loans	$	608,540	$	41,311	$	12,611	$	63,399	$	6	$	725,867

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	Risk Rating at December 31, 2010
					Special
	Pass		Pass Watch		Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	62,969	$	3,908	$	7,813	$	228	$	22	$	74,940
Commercial real estate:
Owner occupied		65,768		20,239		4,310		9,118		—		99,435
Non-owner occupied		142,636		25,191		2,448		21,723		—		191,998
Multifamily		61,822		8,238		708		1,312		—		72,080
Commercial construction and           land development		10,138		4,989		—		9,183		—		24,310
Commercial participations		14,095		—		—		9,499		—		23,594
Total commercial loans		357,428		62,565		15,279		51,063		22		486,357
Retail loans:
One-to-four family residential		181,991		—		107		3,223		—		185,321
Home equity lines of credit		55,688		—		—		489		—		56,177
Retail construction		2,973		—		—		203		—		3,176
Other		2,118		—		—		4		—		2,122
Total retail loans		242,770		—		107		3,919		—		246,796
Total loans	$	600,198	$	62,565	$	15,386	$	54,982	$	22	$	733,153

					Special
	Pass		Pass Watch		Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Current	$	589,067	$	61,449	$	11,857	$	13,770	$	22	$	676,165
Delinquent:
30-59 days		5,347		457		415		540		—		6,759
60-89 days		5,322		536		768		321		—		6,947
90 days or more		462		123		2,346		40,351		—		43,282
Total loans	$	600,198	$	62,565	$	15,386	$	54,982	$	22	$	733,153

For all loan categories, past due status is based on the contractual terms of the loan.  Interest income is generally not accrued on loans which are delinquent 90 days or more, or for loans which management believes, after giving consideration to a number of factors, including economic and business conditions and collection efforts, collection of interest is doubtful.  In all cases, loans are placed on non-accrual status or charged-off at an earlier date if collection of principal or interest is considered doubtful.  All interest accrued but not received for loans placed on non-accrual is reversed against interest income.  Interest subsequently received on non-accrual loans is accounted for using the cost-recovery basis for commercial loans and the cash-basis for retail loans until qualifying for return to accrual status.

Commercial loans are generally placed on non-accrual once they become 90 days past due.  Management reviews all current financial information of the borrower and guarantor(s) and action plans to bring the loan current before determining if the loan should be placed on non-accrual.  Management requires appropriate justification to maintain a commercial loan on accrual status once 90 days past due.  Occasionally commercial loans are placed on non-accrual status before the loan becomes significantly past due if current information indicates that future repayment of principal and interest may be questionable.

Commercial loans are returned to accrual status only when the loan has been paid as agreed for a minimum of six months.  A detailed analysis of the borrower and guarantor’s ability to service the loan is

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completed and must meet the Company’s underwriting standards and conform to Company policy before the loan can be returned to accrual status.

Retail loans are returned to accrual status primarily based on the payment status of the loan.  A retail loan is automatically placed on non-accrual status immediately upon becoming 90 days past due.  The loan remains on non-accrual status, with interest income recognized on a cash basis when a payment is made, until the loan is paid current.  Once current, the loan is automatically returned to accrual status.  If management identifies other information to indicate that future repayment of the loan balance may still be questionable, the loan may be manually moved to non-accrual status until management determines otherwise.

The Company’s loan portfolio delinquency status is summarized as follows:

	Delinquency at September 30, 2011
													Loans
	30-59		60-89		Greater		Total				Total		> 90 Days
	Days Past		Days Past		Than 90		Past				Loans		And
	Due		Due		Days		Due		Current		Receivable		Accruing
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	78	$	41	$	186	$	305	$	83,264	$	83,569	$	91
Commercial real estate:
Owner occupied		5,097		—		9,001		14,098		86,146		100,244		—
Non-owner occupied		5,917		1,270		11,752		18,939		174,328		193,267		5
Multifamily		516		1,263		176		1,955		68,174		70,129		—
Commercial construction and           land development		475		—		7,707		8,182		14,453		22,635		—
Commercial participations		—		—		6,442		6,442		10,297		16,739		—
Total commercial loans		12,083		2,574		35,264		49,921		436,662		486,583		96
Retail loans:
One-to-four family residential		3,392		1,439		4,097		8,928		172,097		181,025		—
Home equity lines of credit		329		—		604		933		53,020		53,953		—
Retail construction		46		—		169		215		1,084		1,299		—
Other		5		1		—		6		3,001		3,007		—
Total retail loans		3,772		1,440		4,870		10,082		229,202		239,284		—
Total loans receivable	$	15,855	$	4,014	$	40,134	$	60,003	$	665,864	$	725,867	$	96

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	Delinquency at December 31, 2010
													Loans
	30-59		60-89		Greater		Total				Total		> 90 Days
	Days Past		Days Past		Than 90		Past				Loans		And
	Due		Due		Days		Due		Current		Receivable		Accruing
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	448	$	664	$	180	$	1,292	$	73,648	$	74,940	$	—
Commercial real estate:
Owner occupied		678		3,691		11,464		15,833		83,602		99,435		2,346
Non-owner occupied		361		216		9,081		9,658		182,340		191,998		123
Multifamily		656		—		436		1,092		70,988		72,080		—
Commercial construction and           land development		—		536		9,023		9,559		14,751		24,310		—
Commercial participations		—		—		9,660		9,660		13,934		23,594		—
Total commercial loans		2,143		5,107		39,844		47,094		439,263		486,357		2,469
Retail loans:
One-to-four family residential		4,229		1,832		2,589		8,650		176,671		185,321		—
Home equity lines of credit		386		8		642		1,036		55,141		56,177		—
Retail construction		—		—		203		203		2,973		3,176		—
Other		1		—		4		5		2,117		2,122		—
Total retail loans		4,616		1,840		3,438		9,894		236,902		246,796		—
Total loans receivable	$	6,759	$	6,947	$	43,282	$	56,988	$	676,165	$	733,153	$	2,469

Non-accrual loans are summarized as follows:

	September 30,		December 31,
	2011		2010
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	571	$	228
Commercial real estate:
Owner occupied		12,296		9,119
Non-owner occupied		25,664		21,512
Multifamily		783		1,071
Commercial construction and land development		7,707		9,183
Commercial participations		6,442		9,499
Total commercial loans		53,463		50,612
Retail loans:
One-to-four family residential		4,908		2,955
Home equity lines of credit		795		718
Retail construction		169		203
Other		—		4
Total retail loans		5,872		3,880
Total non-accrual loans	$	59,335	$	54,492

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The Company’s impaired loans are summarized as follows with the majority of the interest income recognized on a cash basis at the time the payment is received:

									Three Months Ended				Nine Months Ended
	At September 30, 2011								September 30, 2011				September 30, 2011
			Unpaid		Partial				Average		Interest		Average		Interest
	Recorded		Principal		Charge-offs		Related		Recorded		Income		Recorded		Income
	Investment		Balance		to Date		Allowance		Investment		Recognized		Investment		Recognized
	(Dollars in thousands)
Loans without a specific valuation allowance:
Commercial and industrial	$	2,902	$	3,118	$	216	$	—	$	3,111	$	36	$	3,918	$	121
Commercial real estate:
Owner occupied		9,339		9,494		4		—		9,363		—		9,288		—
Non-owner occupied		7,145		7,391		140		—		7,148		81		7,582		212
Multifamily		675		675		—		—		675		13		678		26
Commercial construction and land development		7,171		9,103		1,931		—		7,171		—		7,171		—
Commercial participations		1,140		3,148		1,946		—		1,140		—		1,367		—
Retail		8,481		8,702		222		—		8,586		53		8,647		138
Total	$	36,853	$	41,631	$	4,459	$	—	$	37,194	$	183	$	38,651	$	497
Loans with a specific valuation allowance:
Commercial real estate:
Owner occupied	$	4,397	$	4,939	$	—	$	398	$	4,414	$	38	$	4,518	$	38
Non-owner occupied		21,754		22,696		—		4,667		21,845		—		22,116		—
Commercial participations		5,302		5,443		—		3,593		5,302		—		5,302		—
Total	$	31,453	$	33,078	$	—	$	8,658	$	31,561	$	38	$	31,936	$	38
Total impaired loans:
Commercial	$	59,825	$	66,007	$	4,237	$	8,658	$	60,169	$	168	$	61,940	$	397
Retail		8,481		8,702		222		—		8,586		53		8,647		138
Total	$	68,306	$	74,709	$	4,459	$	8,658	$	68,755	$	221	$	70,587	$	535

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									Twelve Months Ended
	At December 31, 2010								December 31, 2010
			Unpaid		Partial				Average		Interest
	Recorded		Principal		Charge-offs		Related		Recorded		Income
	Investment		Balance		to Date		Allowance		Investment		Recognized
	(Dollars in thousands)
Loans without a specific valuation allowance:
Commercial and industrial	$	3,692	$	3,976	$	1,506	$	—	$	4,738	$	128
Commercial real estate:
Owner occupied		5,041		5,082		—		—		5,059		—
Non-owner occupied		6,664		6,834		140		—		6,695		144
Multifamily		264		264		—		—		268		4
Commercial construction and land development		9,183		11,498		2,314		—		9,313		—
Commercial participations		4,197		8,012		3,753		—		4,397		—
Retail		2,847		2,891		90		—		2,758		122
Total	$	31,888	$	38,557	$	7,803	$	—	$	33,228	$	398
Loans with a specific valuation allowance:
Commercial real estate:
Owner occupied	$	2,798	$	3,168	$	—	$	433	$	2,900	$	—
Non-owner occupied		17,850		18,311		—		4,492		18,066		—
Commercial participations		5,302		5,443		—		3,497		5,302		—
Total	$	25,950	$	26,922	$	—	$	8,422	$	26,268	$	—
Total impaired loans:
Commercial	$	54,991	$	62,588	$	7,713	$	8,422	$	56,738	$	276
Retail		2,847		2,891		90		—		2,758		122
Total	$	57,838	$	65,479	$	7,803	$	8,422	$	59,496	$	398

The Company may grant a concession or modification for economic or legal reasons related to a borrower’s financial condition that it would not otherwise consider resulting in a modified loan which is then identified as a troubled debt restructuring (TDR).  The Company may modify loans through rate reductions, short-term extensions of maturity, interest only payments, or payment modifications to better match the timing of cash flows due under the modified terms with the cash flows from the borrowers’ operations.  Loan modifications are intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral.  TDRs are considered impaired loans for purposes of calculating the Company’s allowance for loan losses.

The Company identifies loans for potential restructure primarily through direct communication with the borrower and evaluation of the borrower’s financial statements, revenue projections, tax returns, and credit reports.  Even if the borrower is not presently in default, management will consider the likelihood that cash flow shortages, adverse economic conditions, and negative trends may result in a payment default in the near future.

For one-to-four family residential and home equity lines of credit, a restructure often occurs with past due loans and may be offered as an alternative to foreclosure.  There are other situations where borrowers, who are not past due, experience a sudden job loss, become over-extended with credit obligations, or other problems, have indicated that they will be unable to make the required monthly payment and request payment relief.

When considering a loan restructure, management will determine if:  (i) the financial distress is short or long term; (ii) loan concessions are necessary; and (iii) the restructure is a viable solution.

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When a loan is restructured, the new terms often require a reduced monthly debt service payment.  No TDRs that were on non-accrual status at the time the concessions were granted have been returned to accrual status.  For commercial loans, management completes an analysis of the operating entity’s ability to repay the debt.  If the operating entity is capable of servicing the new debt service requirements and the underlying collateral value is believed to be sufficient to repay the debt in the event of a future default, the new loan is generally placed on accrual status.  To date, there have been no commercial loans restructured and immediately placed on accrual status after the execution of the TDR.

For retail loans, an analysis of the individual’s ability to service the new required payments is performed.  If the borrower is capable of servicing the newly restructured debt and the underlying collateral value is believed to be sufficient to repay the debt in the event of a future default, the new loan is generally placed on accrual status.  The reason for the TDR is also considered, such as paying past due real estate taxes or payments caused by a temporary job loss, when determining whether a retail TDR loan could be returned to accrual status.  Retail TDRs remain on non-accrual status until sufficient payments have been made to bring the past due principal and interest current at which point the loan would be transferred to accrual status.

Effective July 1, 2011, the Company adopted the provisions of Accounting Standards Update (ASU) No. 2011-02, Receivables (Topic 310):  A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.  As a result of adopting the provisions of ASU 2011-02, the Company reassessed all loan modifications occurring since January 1, 2011 for identification as TDRs resulting in one newly identified one-to-four family residential TDR totaling $33,000.

The following table summarizes the loans that have been restructured as TDRs during the three and nine months ended September 30, 2011:

	Three Months Ended						Nine Months Ended
	September 30, 2011						September 30, 2011
			Balance		Balance				Balance		Balance
			prior to		after				prior to		after
	Count		TDR		TDR		Count		TDR		TDR
	(Dollars in thousands)
Commercial:
Commercial and industrial		4	$	995	$	995		4	$	995	$	995
Commercial real estate:
Owner occupied		1		1,861		1,861		2		2,459		2,415
Non-owner occupied		1		107		107		1		107		107
Total commercial loans		6		2,963		2,963		7		3,561		3,517
Retail:
One-to-four family residential		3		171		183		9		909		962
Total retail loans		3		171		183		9		909		962
Total loans		9	$	3,134	$	3,146		16	$	4,470	$	4,479

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The following table sets forth the Company’s TDRs that had payment defaults during 2011.  Default occurs when a TDR is 90 days or more past due, transferred to non-accrual status, or transferred to other real estate owned within twelve months of restructuring.  Of the total, one loan totaling $248,000 was subsequently foreclosed and is included in the September 30, 2011 other real estate owned balance.

			Default
	Count		Balance
	(Dollars in thousands)
Retail loans:
One-to-four family residential		5	$	695

The tables below summarize the Company’s TDRs by loan category and accrual status:

	September 30, 2011						December 31, 2010
	Accruing		Non-accruing		Total		Accruing		Non-accruing		Total
	(Dollars in thousands)
Commercial:
Commercial and industrial	$	2,379	$	471	$	2,850	$	3,575	$	—	$	3,575
Commercial real estate:
Owner occupied		1,861		3,295		5,156		—		3,051		3,051
Non-owner occupied		3,823		18,194		22,017		3,296		19,234		22,530
Multifamily		260		—		260		264		—		264
Commercial construction and         land development		—		—		—		—		2,012		2,012
Commercial participations		—		5,302		5,302		—		5,302		5,302
Total commercial		8,323		27,262		35,585		7,135		29,599		36,734
Retail:
One-to-four family residential		2,608		625		3,233		2,619		228		2,847
Home equity lines of credit		—		—		—		—		—		—
Retail construction		—		—		—		—		—		—
Other		—		—		—		—		—		—
Total retail		2,608		625		3,233		2,619		228		2,847
Total troubled debt restructurings	$	10,931	$	27,887	$	38,818	$	9,754	$	29,827	$	39,581

Management monitors the TDRs based on the type of modification or concession granted to the borrower.  These types of modifications may include rate reductions, payment/term extensions, forgiveness of principal, forbearance, and other applicable actions.  Of the various noted concessions, management predominantly utilizes rate reductions and lower monthly payments, either from a longer amortization period or interest only repayment schedule, because these concessions provide needed payment relief without risking the loss of principal.  Management will also agree to a forbearance agreement when it is deemed appropriate to avoid foreclosure.

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The following tables set forth the Company’s TDRs by portfolio segment to quantify the type of modification or concession provided:

	September 30, 2011
													Total
	Commercial		Commercial Real Estate								One-to-four		Troubled
	and		Owner		Non-Owner				Commercial		Family		Debt
	Industrial		Occupied		Occupied		Multifamily		Participations		Residential		Restructurings
	(Dollars in thousands)
Rate reduction	$	—	$	—	$	—	$	—	$	—	$	641	$	641
Payment extension		2,646		3,295		2,202		—		—		955		9,098
Rate reduction and payment extension		—		—		545		260		—		1,637		2,442
Rate reduction and interest only		—		—		12,596		—		—		—		12,596
Payment extension and interest only		—		1,861		—		—		—		—		1,861
Forbearance		—		—		6,674		—		5,302		—		11,976
Additional collateral collected		204		—		—		—		—		—		204
Total troubled debt restructurings	$	2,850	$	5,156	$	22,017	$	260	$	5,302	$	3,233	$	38,818

	December 31, 2010
															Total
	Commercial		Commercial Real Estate						Construction				One-to-four		Troubled
	and		Owner		Non-Owner				and Land		Commercial		Family		Debt
	Industrial		Occupied		Occupied		Multifamily		Development		Participations		Residential		Restructurings
	(Dollars in thousands)
Rate reduction	$	—	$	—	$	—	$	—	$	—	$	—	$	396	$	396
Payment extension		3,575		3,051		2,113		—		—		—		1,043		9,782
Rate reduction and payment extension		—		—		566		264		—		—		1,408		2,238
Rate reduction and interest only		—		—		12,955		—		—		—		—		12,955
Forbearance		—		—		6,896		—		2,012		5,302		—		14,210
Total troubled debt restructurings	$	3,575	$	3,051	$	22,530	$	264	$	2,012	$	5,302	$	2,847	$	39,581

At September 30, 2011, TDRs totaled $38.8 million, of which $8.0 million were performing in accordance with their modified terms and accruing.  The Company’s TDRs which are performing in accordance with their agreements and on non-accrual status totaled $21.3 million at September 30, 2011.  At September 30, 2011, commercial TDRs included $35.6 million loans that were restructured, of which $27.3 million were on non-accrual status.  Of the $3.2 million retail TDRs, $1.5 million were still performing in accordance with their agreements and $625,000 were on non-accrual status.  The decrease in TDRs since December 31, 2010 was primarily due to repayments and payoffs of $2.9 million coupled with transfers to other real estate owned totaling $2.0 million and partially offset by new TDRs totaling $4.2 million.

6.   Fair Value Measurements

The Company measures fair value according to ASC 820-10: Fair Value Measurements and Disclosures.  ASC 820-10 establishes a fair value hierarchy that prioritizes the inputs used in valuation techniques, but not the valuation techniques themselves.  The fair value hierarchy is designed to indicate the relative reliability of the fair value measure.  The highest priority is given to quoted prices in active markets and the lowest to unobservable data such as the Company’s internal information.  ASC 820-10 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  There are three levels of inputs into the fair value hierarchy (Level 1 being the highest priority and Level 3 being the lowest priority):

Level 1 – Unadjusted quoted prices for identical instruments in active markets;

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Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable; and

Level 3 – Instruments whose significant value drivers or assumptions are unobservable and that are significant to the fair value of the assets or liabilities.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The following tables set forth the Company’s financial assets by level within the fair value hierarchy that were measured at fair value on a recurring basis at the dates indicated.

			Fair Value Measurements at September 30, 2011
	Fair Value		Quoted Prices  in Active Markets for Identical Assets (Level 1)		Significant  Other  Observable  Inputs (Level 2)		Significant Unobservable  Inputs (Level 3)
	(Dollars in thousands)
Investment securities available-for-sale:
U.S. Treasury securities	$	15,405	$	—	$	15,405	$	—
GSE securities		53,588		—		53,588		—
Corporate bonds		3,743		—		3,743		—
Collateralized mortgage obligations		51,148		—		51,148		—
Commercial mortgage-backed securities		77,524		—		77,524		—
Pooled trust preferred securities		17,005		—		—		17,005
GSE preferred stock		4		4		—		—

			Fair Value Measurements at December 31, 2010
	Fair Value		Quoted Prices  in Active  Markets for  Identical  Assets (Level 1)		Significant  Other Observable  Inputs (Level 2)		Significant Unobservable  Inputs (Level 3)
	(Dollars in thousands)
Investment securities available-for-sale:
U.S. Treasury securities	$	14,819	$	—	$	14,819	$	—
GSE securities		31,020		—		31,020		—
Corporate bonds		3,586		—		3,586		—
Collateralized mortgage obligations		60,755		—		60,755		—
Commercial mortgage-backed securities		68,698		—		68,698		—
Pooled trust preferred securities		18,125		—		—		18,125
GSE preferred stock		98		98		—		—

Level 1 investment securities are valued using quoted prices in active markets for identical assets.  The Company uses Level 1 prices for its GSE preferred stock.

Level 2 investment securities are valued by a third party pricing service commonly used in the banking industry utilizing observable inputs.  The pricing provider utilizes evaluated pricing models that vary based on

28

asset class.  These models incorporate available market information including quoted prices of investment securities with similar characteristics and, because many fixed-income investment securities do not trade on a daily basis, apply available information through processes such as benchmark yield curves, benchmarking of like investment securities, sector groupings, and matrix pricing.  In addition, model processes, such as an option adjusted spread model, are used to develop prepayment estimates and interest rate scenarios for investment securities with prepayment features.

Management uses a recognized third-party pricing service to obtain market values for the Company’s fixed income securities portfolio.  Documentation is maintained as to the methodology and summary of inputs used by the pricing service for the various types of securities, and management notes that the servicer maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs.  Management does not have access to all of the individual specific assumptions and inputs used for each security.  The significant observable inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including market research publications.

Management validates the market values against fair market curves and other available pricing sources. Bloomberg pricing is used to compare the reasonableness of the third-party pricing service prices for U.S. Treasury securities and government sponsored entity (GSE) bonds.  For all securities, the Company’s Investment Officer, who is in the market on a regular basis, monitors the market and is familiar with where similar securities are trading and where specific bonds in specific sectors should be priced.  All monthly output from the third-party provider is reviewed against expectations as to pricing based on fair market curves, ratings, coupon, structure, and recent trade reports or offerings.

Based on management’s review of the methodology and summary of inputs used, management has concluded these assets are properly classified as Level 2 assets.

Level 3 models are utilized when quoted prices are not available for certain investment securities or in markets where trading activity has slowed or ceased.  When quoted prices are not available and are not provided by third party pricing services, management judgment is necessary to determine fair value.  As such, fair value is determined by using discounted cash flow analysis models, incorporating default rate assumptions, estimations of prepayment characteristics, and implied volatilities.

The Company determined that Level 3 pricing models should be utilized for valuing its pooled trust preferred investment securities.  The markets for these securities and for similar securities at September 30, 2011 were illiquid.  There have been a limited number of observable transactions in the secondary market, however, a new issue market does not exist.  Management has determined a valuation approach that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be more representative of fair value than the market approach valuation technique.

For its Level 3 pricing model, the Company uses externally produced fair values provided by a third party and compares them to other external pricing sources. Other external sources provided similar prices, both higher and lower, than those used by the Company.  The external model uses observed prices from limited transactions on similar securities to estimate liquidation values.

The following is a reconciliation of the beginning and ending balances for the periods indicated of recurring fair value measurements recognized in the accompanying consolidated statements of condition using Level 3 inputs:

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	Pooled Trust Preferred Securities
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010
	(Dollars in thousands)
Beginning balance	$	18,371		$	20,124		$	18,125		$	20,012
Total realized and unrealized gains and losses:
Included in accumulated other comprehensive income (loss)		(1,189	)		(1,107	)		133			(771	)
Principal repayments		(177	)		(104	)		(1,253	)		(328	)
Ending balance	$	17,005		$	18,913		$	17,005		$	18,913

The following table sets forth the Company’s financial and non-financial assets by level within the fair value hierarchy that were measured at fair value on a non-recurring basis at the dates indicated.

			Fair Value Measurements at September 30, 2011
	Fair Value		Quoted Prices  in Active  Markets for  Identical Assets (Level 1)		Significant  Other  Observable  Inputs (Level 2)		Significant  Unobservable  Inputs (Level 3)
	(Dollars in thousands)
Impaired loans	$	14,087	$	—	$	—	$	14,087
Other real estate owned		1,420		—		—		1,420

			Fair Value Measurements at December 31, 2010
	Fair Value		Quoted Prices  in Active  Markets for  Identical Assets (Level 1)		Significant  Other Observable  Inputs (Level 2)		Significant  Unobservable  Inputs (Level 3)
	(Dollars in thousands)
Impaired loans	$	15,258	$	—	$	—	$	15,258
Other real estate owned		4,837		—		—		4,837

Loans for which it is probable that the Bank will not collect all principal and interest due according to contractual terms are measured for impairment.  Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral-dependent loans.  If the impaired loan is identified as collateral-dependent, then the fair value method of measuring the amount of impairment is utilized.

The Bank generally obtains and reviews annual appraisals for collateral dependent loans.  Management had previously discounted older appraisals based on estimated changes in market values, but ceased utilizing this technique in early 2009 due to the continued softness in the real estate markets.  For purchased participation loans, management is dependent upon the lead bank to order and provide appraisals, which occasionally are broker’s opinions.

In determining the estimated fair value of the real estate, senior liens such as unpaid and current real estate taxes and any perfected liens are subtracted from the value.  In addition, the Company generally applies a 10% discount to the current appraisal to allow for reasonable selling expenses, including sales commissions and closing costs.  Impaired loans that are collateral-dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.

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Fair value measurements for impaired loans are performed pursuant to ASC 310-10, Receivables, and are measured on a non-recurring basis.  Certain impaired loans were partially charged-off or re-evaluated during the third quarter of 2011.  These impaired loans were carried at fair value as estimated using current and prior appraisals, discounting factors, the borrowers’ financial results, estimated cash flows generated from the property, and other factors.  The change in the fair value of impaired loans that were valued based upon Level 3 inputs was approximately $2.5 million and $102,000 for the three months ended September 30, 2011 and 2010, respectively and $3.3 million and $3.7 million for the nine months ended September 30, 2011 and 2010, respectively.  These losses are not recorded directly as an adjustment to current earnings or other comprehensive income (loss), but rather as a component in determining the overall adequacy of the allowance for loan losses.  These adjustments to the estimated fair value of impaired loans may result in increases or decreases to the provision for loan losses recorded in future earnings.

The fair value of the Company’s other real estate owned is determined by using Level 3 inputs which include current and prior appraisals and estimated costs to sell.  The reduction in fair value of other real estate owned was $316,000 and $210,000 for the three months ended September 30, 2011 and 2010, respectively, and $2.1 million and $642,000 for the nine months ended September 30, 2011 and 2010, respectively.  The changes were recorded as adjustments to current earnings through other real estate owned related expenses.

The Company has the option to measure financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the Fair Value Option) according to ASC 825-10, Financial Instruments.  The Company is not currently engaged in any hedging activities and, as a result, did not elect to measure any financial instruments at fair value under ASC 825-10.

Disclosure of fair value information about financial instruments, whether or not recognized in the consolidated statement of condition, for which it is practicable to estimate their value, is summarized below.  The aggregate fair value amounts presented do not represent the underlying value of the Company.

The carrying amounts and fair values of financial instruments consist of the following:

	September 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
	(Dollars in thousands)
Financial Assets:
Cash and cash equivalents	$	117,765	$	117,765	$	61,754	$	61,754
Investment securities, available-for-sale		218,417		218,417		197,101		197,101
Investment securities, held-to-maturity		14,387		14,694		17,201		17,426
Federal Home Loan Bank stock		8,638		8,638		20,282		20,282
Loans receivable, including loans held for sale, net of    allowance for loan losses		709,120		712,745		715,405		718,556
Interest receivable		2,908		2,908		3,162		3,162
Total financial assets	$	1,071,235	$	1,075,167	$	1,014,905	$	1,018,281
Financial Liabilities:
Deposits	$	986,441	$	988,909	$	945,884	$	948,804
Borrowed funds		56,115		59,081		53,550		55,572
Interest payable		78		78		106		106
Total financial liabilities	$	1,042,634	$	1,048,068	$	999,540	$	1,004,482

The carrying amount is the estimated fair value for cash and cash equivalents and accrued interest receivable and payable.  Investment securities fair values are based on quotes received from a third-party

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pricing source and discounted cash flow analysis models.  The fair value of Federal Home Loan Bank stock is based on its redemption value.  The fair values for loans receivable are estimated using discounted cash flow analyses.  Cash flows are adjusted for estimated prepayments where appropriate and are discounted using interest rates currently being offered for loans with similar terms and collateral to borrowers of similar credit quality.

The fair value of checking, savings, and money market accounts is the amount payable on demand at the reporting date.  The fair value of fixed-maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.  The fair value of borrowed funds is estimated based on rates currently available to the Company for debt with similar terms and remaining maturities.  The fair value of the Company’s off-balance sheet instruments, including lending commitments, letters of credit, and credit enhancements, approximates their book value and is not included in the above table.

7. Share-Based Compensation

The Company accounts for its stock options in accordance with ASC 718-10, Compensation – Stock Based Compensation.  ASC 718-10 addresses all forms of share-based payment awards, including shares under employee stock purchase plans, stock options, restricted stock, and stock appreciation rights.  ASC 718-10 requires all share-based payments to be recognized as expense, based upon their fair values, in the financial statements over the service period of the awards.

For additional details on the Company’s share-based compensation plans and related disclosures, see “Note 9.  Share-Based Compensation” in the consolidated financial statements as presented in the Company’s 2010 Annual Report on Form 10-K.

Omnibus Equity Incentive Plan

The Company’s 2008 Omnibus Equity Incentive Plan (Equity Incentive Plan) authorized the issuance of 270,000 shares of its common stock.  In addition, there were 64,500 shares that had not yet been issued or were forfeited, cancelled, or unexercised at the end of the option term under the 2003 Stock Option Plan when it was frozen.  These shares and any other shares that may be forfeited, cancelled, or expired are available for any type of stock-based awards in the future under the Equity Incentive Plan.  At September 30, 2011, 166,051 shares were available for future grants under the Equity Incentive Plan.

Restricted Stock

The following table presents the activity for restricted stock for the nine months ended September 30, 2011.

				Weighted- Average
	Number of			Grant-Date
	Shares			Fair Value
Unvested at December 31, 2010		188,027		$	4.98
Granted		54,915			5.62
Vested		(30,160	)		7.90
Forfeited		(36,376	)		3.57
Unvested as of September 30, 2011		176,406		$	4.96

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The compensation expense related to restricted stock for the three months ended September 30, 2011 and 2010 totaled $81,000 and $63,000, respectively.  The compensation expense related to restricted stock for the nine months ended September 30, 2011 and 2010 totaled $226,000 and $181,000, respectively.  At September 30, 2011, the remaining unamortized cost of the restricted stock awards was reflected as a reduction in additional paid-in capital and totaled $877,000.  This cost is expected to be recognized over a weighted-average period of 2.6 years which is subject to the actual number of shares earned and vested.

Stock Options

The Company has stock option plans under which shares of Company common stock were reserved for the grant of both incentive and non-qualified stock options to directors, officers, and employees.  These plans were frozen in conjunction with the approval of the Equity Incentive Plan in 2008 and no new awards will be made under these plans.  The stock option vesting periods and exercise and expiration dates were determined by the Compensation Committee at the time of the grant.  The exercise price of the stock options is equal to the fair market value of the common stock on the grant date.

The following table presents the activity under the Company’s stock option plans for the nine months ended September 30, 2011.

	2011
				Weighted-
				Average
	Number of			Exercise
	Options			Price
Options outstanding and exercisable at December 31, 2010		650,995		$	13.44
Granted		—			—
Exercised		—			—
Forfeited		(2,000	)		14.24
Expired unexercised		(132,500	)		11.25
Options outstanding and exercisable at September 30, 2011		516,495		$	14.01

For stock options outstanding at September 30, 2011, the range of exercise prices was $13.48 to $14.76 and the weighted-average remaining contractual term was 2.3 years.  At September 30, 2011, all of the Company’s outstanding stock options were out-of-the-money and had no intrinsic value.  There were no stock options exercised during the nine months ended September 30, 2011 and 2010.  The Company reissues treasury shares to satisfy option exercises.

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8. Other Comprehensive Income (Loss)

The related income tax effect and reclassification adjustments to the components of other comprehensive income (loss) for the periods indicated are as follows:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010
	(Dollars in thousands)
Unrealized holding gains (losses) arising during the period:
Unrealized net gains (losses)	$	(1,873	)	$	513		$	1,237		$	2,154
Related tax (expense) benefit		663			(161	)		(461	)		(729	)
Net unrealized gains (losses)		(1,210	)		352			776			1,425
Less:  reclassification adjustment for net gains realized during the period:
Realized net gains		758			—			1,450			456
Related tax expense		(272	)		—			(525	)		(155	)
Net realized gains		486			—			925			301
Total other comprehensive income (loss)	$	(1,696	)	$	352		$	(151	)	$	1,124

9. Recent Accounting Pronouncements

In September 2011, the Financial Accounting Standards Board (FASB) issued ASU No. 2011-09, Compensation – Retirement Benefits – Multiemployer Plans.  ASU 2011-09 requires companies who participate in multiemployer benefit plans to provide additional separate quantitative and qualitative disclosures for multiemployer pension plans and multiemployer other postretirement benefit plans.  For companies that participate in multiemployer pension plans, the ASU requires detailed information including the plan names and identifying number, level of an employer’s participation including the amount of an employer’s contributions, the financial health of a multiemployer plan including an indication of the funded status, pending changes in funding plans, and surcharges on the contributions to the plan, and the nature of the employer commitments to the plan.  In addition, if public information is not available outside of the employer’s financial statements about the plan, the employer is required to make additional disclosures including a description of the nature of the plan benefits, a qualitative description of the extent to which the employer could be responsible for the obligations of the plan, and other quantitative information, if available, about the plan such as total assets, actuarial present value of accumulated plan benefits, and total contributions received by the plan.  The ASU is effective for public companies for annual periods for fiscal years ending after December 15, 2011.  The Company participates in a multiemployer pension plan and will be required to include additional disclosures related to the ASU.   The Company is currently evaluating the impact the ASU will have on its disclosures in its Annual Report on Form 10-K for the year ended December 31, 2011.

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 22):  Presentation of Comprehensive Income.  ASU 2011-05 requires companies to present the components of net income and other comprehensive income either as one continuous statement or as two consecutive statements.  The ASU eliminates the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity.  ASU 2011-05 does not change the items which must be reported in other comprehensive income, how such items are measured, or when they must be reclassified to net income.  This ASU is effective for interim and annual periods beginning after December 15, 2011.  The Company intends to adopt the disclosures required by this ASU by the date required and it will have no impact on the Company’s financial condition, results of operations, or cash flows.

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In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820):  Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.  ASU 2011-04 is intended to result in convergence between United States Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) requirements for measurement of and disclosures about fair value.  The amendments are not expected to have a significant impact on companies applying U.S. GAAP.  Key provisions of the amendment include:  a prohibition on grouping financial instruments for purposes of determining fair value, except when an entity manages market and credit risks on the basis of the entity’s net exposure to the group; an extension of the prohibition against the use of a blockage factor to all fair value measurements (that prohibition currently applies only to financial instruments with quoted prices in active markets); and a requirement that for recurring Level 3 fair value measurements, entities disclose quantitative information about unobservable inputs, a description of the valuation process used, and qualitative details about the sensitivity of the measurements.  In addition, for items not carried at fair value but for which fair value is disclosed, entities will be required to disclose the level within the fair value hierarchy that applies to the fair value measurement disclosed.  This ASU is effective for interim and annual periods beginning after December 15, 2011.  The adoption of this ASU is not expected to have a significant impact on the Company’s fair value measurements, financial condition, results of operations, or cash flows.

In April 2011, the FASB issued ASU No. 2011-03, Transfers and Servicing (Topic 860):  Reconsideration of Effective Control for Repurchase Agreements.  ASU 2011-03 amends the sale accounting requirement concerning a transferor’s ability to repurchase transferred financial assets even in the event of default by the transferee, which typically is facilitated in a repurchase agreement by the presence of a collateral maintenance provision.  Specifically, the level of cash collateral received by a transferor will no longer be relevant in determining whether a repurchase agreement constitutes a sale.  As a result of this amendment, more repurchase agreements will be treated as secured financings rather than sales.  This ASU is effective prospectively for new transfers and existing transactions that are modified in the first interim or annual period beginning on or after December 15, 2011.  Because essentially all repurchase agreements entered into by the Company have historically been deemed to constitute secured financing transactions, this amendment is expected to have no impact on the Company’s characterization of such transactions and therefore is not expected to have any impact on the Company’s financial condition, results of operation, or cash flows.

In April 2011, the FASB issued ASU No. 2011-02, Receivables (Topic 310):  A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.  ASU 2011-02 clarifies the guidance in ASC 310-40 Receivables:  Troubled Debt Restructurings by Creditors.  Creditors are required to identify a restructuring as a troubled debt restructuring if the restructuring constitutes a concession and the debtor is experiencing financial difficulties.  ASU 2011-02 clarifies guidance on whether a creditor has granted a concession and clarifies the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulties.  In addition, ASU 2011-02 also precludes the creditor from using the effective interest rate test in the debtor’s guidance on restructuring of payables when evaluating whether a restructuring constitutes a troubled debt restructuring.  The effective date of ASU 2011-02 for public entities is effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption.  If, as a result of adoption, an entity identifies newly impaired receivables, an entity should apply the amendments for purposes of measuring impairment prospectively for the first interim or annual period beginning on or after June 15, 2011.  The Company adopted the methodologies prescribed by this ASU on July 1, 2011 with no material impact on its financial condition, results of operation, and cash flows or on the total TDRs identified by the Company.

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Item 2.          Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement Regarding Forward Looking Statements

Certain statements contained in this Form 10-Q, in our other filings with the U.S. Securities and Exchange Commission (SEC), and in our press releases or other shareholder communications are forward-looking statements, as that term is defined in U.S. federal securities laws.  Generally, these statements relate to our business plans or strategies, projections involving anticipated revenues, earnings, profitability, or other aspects of operating results, or other future developments in our affairs or the industry in which we conduct business.  Forward-looking statements may be identified by reference to a future period or periods or by the use of forward-looking terminology such as “anticipate,” “believe,” “expect,” “intend,” “plan,” “estimate,” “would be,” “will,” “intend to,” “project,”  or similar expressions or the negative thereof, as well as statements that include future events, tense or dates, or are not historical or current facts.

We wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made.  These forward-looking statements include but are not limited to statements regarding our ability to successfully execute our strategy and Strategic Growth and Diversification Plan, the level and sufficiency of our current regulatory capital and equity ratios, our ability to continue to diversify the loan portfolio, our efforts at deepening client relationships, increasing our levels of core deposits, lowering our non-performing asset levels, managing and reducing our credit-related costs, increasing our revenue growth and levels of earning assets, the effects of general economic and competitive conditions nationally and within our core market area, the sufficiency of the levels of provision for the allowance for loan losses and amounts of charge-offs, loan and deposit growth, interest on loans, asset yields and cost of funds, net interest income, net interest margin, non-interest income, non-interest expense, interest rate environment, and other factors.   For further discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements see “Part I. Item 1A.  Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2010.  Such forward-looking statements are not guarantees of future performance.  We do not undertake, and specifically disclaim any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements unless required to do so under the federal securities laws.

Critical Accounting Policies

Our condensed consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP), which require us to establish various accounting policies.  Certain of these accounting policies require us to make estimates, judgments, or assumptions that could have a material effect on the carrying value of certain assets and liabilities.  The estimates, judgments, and assumptions we use are based on historical experience, projected results, internal cash flow modeling techniques, and other factors which we believe are reasonable under the circumstances.

Significant accounting policies are presented in “Note 1. Summary of Significant Accounting Policies” in the notes to our consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of our Annual Report on Form 10-K.  These policies, along with the disclosures presented in other financial statement notes and in this management’s discussion and analysis, provide information on the methodology used for the valuation of significant assets and liabilities in our financial statements.  We view critical accounting policies to be those that are highly dependent on subjective or complex judgments, estimates, and assumptions, and where changes in those estimates and assumptions could have a significant impact on the

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financial statements.  We currently view the determination of the allowance for loan losses, valuations and impairments of investment securities, and the accounting for income taxes to be critical accounting policies.

Allowance for loan losses.  We maintain our allowance for loan losses at a level we believe is appropriate to absorb credit losses inherent in our loan portfolio.  The allowance for loan losses represents our estimate of probable incurred losses in our loan portfolio at each statement of condition date and is based on our review of available and relevant information.

The first component of our allowance for loan losses contains allocations for probable incurred losses that we have identified relating to impaired loans pursuant to ASC 310-10, Receivables.  We individually evaluate for impairment all loans classified substandard and over $750,000.  Loans are considered impaired when, based on current information and events, it is probable that the borrower will not be able to fulfill its obligation according to the contractual terms of the loan agreement.  The impairment loss, if any, is generally measured based on the present value of expected cash flows discounted at the loan’s effective interest rate.  As a practical expedient, impairment may be measured based on the loan’s observable market price, or the fair value of the collateral, if the loan is collateral-dependent.  A loan is considered collateral-dependent when the repayment of the loan will be provided solely by the underlying collateral and there are no other available and reliable sources of repayment.  If we determine a loan is collateral-dependent, we will charge-off any identified collateral shortfall against the allowance for loan losses during the period the shortfall is identified.  As such, each of our collateral-dependent individually impaired loans evaluated under this criteria would not require a specific reserve as it would have already been charged off to the fair value of the collateral (less estimated selling costs).

If foreclosure is probable, we are required to measure the impairment based on the fair value of the collateral.  The fair value of the collateral is generally obtained from appraisals or estimated using an appraisal-like methodology.  When current appraisals are not available, management estimates the fair value of the collateral giving consideration to several factors including the price at which individual unit(s) could be sold in the current market, the period of time over which the unit(s) could be sold, the estimated cost to complete the unit(s), the risks associated with completing and selling the unit(s), the required return on the investment a potential acquirer may have, and the current market interest rates.  The analysis of each loan involves a high degree of judgment in estimating the amount of the loss associated with the loan, including the estimation of the amount and timing of future cash flows and collateral values.

The second component of our allowance for loan losses contains allocations for probable incurred losses within various pools of loans with similar characteristics pursuant to ASC 450-10, Contingencies.  This component is based in part on certain loss factors applied to various stratified loan pools excluding loans evaluated individually for impairment.  In determining the appropriate loss factors for these loan pools, we consider historical charge-offs and recoveries; levels of and trends in delinquencies, impaired loans, and other classified loans; concentrations of credit within the commercial loan portfolios; volume and type of lending; and current and anticipated economic conditions.

Loan losses are charged-off against the allowance when the loan balance or a portion of the loan balance is no longer covered by the paying capacity of the borrower based on an evaluation of available cash resources and collateral value, while recoveries of amounts previously charged-off are credited to the allowance.  We assess the appropriateness of the allowance for loan losses on a quarterly basis and adjust the allowance for loan losses by recording a provision for loan losses in an amount sufficient to maintain the allowance at a level we deem appropriate.  Our evaluation of the appropriateness of the allowance for loan losses is inherently subjective as it requires estimates that are susceptible to significant revision as additional information becomes

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available or as future events occur.  To the extent that actual outcomes differ from our estimates, an additional provision for loan losses could be required which could adversely affect earnings or our financial position in future periods.  Our regulatory agencies could require us to make additional provisions for loan losses.

Investment Securities.  Under ASC 320-10, Investments – Debt and Equity Securities, investment securities must be classified as held-to-maturity, available-for-sale, or trading.  We determine the appropriate classification at the time of purchase.  The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on investment securities.  Debt investment securities are classified as held-to-maturity and carried at amortized cost when we have the positive intent and we have the ability to hold the investment securities to maturity.  Investment securities not classified as held-to-maturity are classified as available-for-sale and are carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income and do not affect earnings until realized.

The fair values of our investment securities are generally determined by reference to quoted prices from reliable independent sources utilizing observable inputs.  Certain of the fair values of investment securities are determined using models whose significant value drivers or assumptions are unobservable and are significant to the fair value of the investment securities.  These models are utilized when quoted prices are not available for certain investment securities or in markets where trading activity has slowed or ceased.  When quoted prices are not available and are not provided by third-party pricing services, our judgment is necessary to determine fair value.  As such, fair value is determined by using discounted cash flow analysis models, incorporating default rates, estimation of prepayment characteristics, and implied volatilities.

We evaluate all investment securities on a quarterly basis, and more frequently when economic conditions warrant additional evaluations, for determining if an other-than-temporary impairment (OTTI) exists pursuant to guidelines established in ASC 320-10.  In evaluating the possible impairment of investment securities, consideration is given to many factors including the length of time and the extent to which the fair value has been less than cost, whether the market decline was affected by macroeconomic conditions, the financial conditions and near-term prospects of the issuer, and our ability and intent to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.  In analyzing an issuer’s financial condition, we may consider whether the investment securities are issued by the federal government or its agencies or government sponsored agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.  The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

If we determine that an investment experienced an OTTI, we must then determine the amount of the OTTI to be recognized in earnings.  If we do not intend to sell the security and it is more likely than not that we will not be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI will be separated into the amount representing the credit loss and the amount related to all other factors.  The amount of the OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings.  The amount of the OTTI related to other factors will be recognized in other comprehensive income, net of applicable taxes.  The previous amortized cost basis less the OTTI recognized in earnings will become the new amortized cost basis of the investment.  If we intend to sell the security or it is more likely than not we will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI will be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date.  Any recoveries related to the value of these investment securities are recorded as an unrealized gain (as other comprehensive income (loss) in shareholders’ equity) and not recognized in income until the security is

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ultimately sold.  From time to time, we may dispose of an impaired security in response to asset/liability management decisions, future market movements, business plan changes, or if the net proceeds can be reinvested at a rate of return that is expected to recover the loss within a reasonable period of time.

Income Tax Accounting.  We file a consolidated federal income tax return.  The provision for income taxes is based upon income in our consolidated financial statements, rather than amounts reported on our income tax return.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect of a change in tax rates on our deferred tax assets and liabilities is recognized as income or expense in the period that includes the enactment date.

Under U.S. GAAP, a valuation allowance is required to be recognized if it is more likely than not that a deferred tax asset will not be realized.  The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning our evaluation of both positive and negative evidence, our forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions.  Positive evidence includes our long-term history of generating taxable income, including seven consecutive quarters of operating taxable income, the existence of taxes paid in available carryback years, and the probability that taxable income will continue to be generated in future periods, while negative evidence includes any cumulative losses in previous years and general business and economic trends.  At September 30, 2011, we conducted an extensive analysis to determine if a valuation allowance was required and concluded that a valuation allowance was not necessary, largely based on our projections of future taxable income and available tax planning strategies.  Additional positive evidence considered in our analysis includes the cyclical nature of the industry in which we operate, as a result, recent losses are not expected to have a significant long-term impact on our profitability; the fact that recent losses were partly attributable to syndicated/participation lending which we stopped investing in during 2007; our history of fully realizing net operating losses, most recently a federal net operating loss from a $45.0 million taxable loss in 2004; and the relatively long remaining tax loss carryforward periods (nineteen years for federal income tax purposes, ten years for the state of Indiana, and eight years for the state of Illinois).  We concluded that the aforementioned positive evidence outweighs the negative evidence of cumulative losses over the past three years.  Any reduction in estimated future taxable income may require us to record a valuation allowance against our deferred tax assets.  Any required valuation allowance would result in additional income tax expense in the period and could have a significant impact on our future earnings.

Positions taken in our tax returns may be subject to challenge by the taxing authorities upon examination.  The benefit of an uncertain tax position is initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities.  Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts.  Differences between our position and the position of tax authorities could result in a reduction of a tax benefit or an increase to a tax liability, which could adversely affect our future income tax expense.

We believe our tax policies and practices are critical accounting policies because the determination of our tax provision and current and deferred tax assets and liabilities have a material impact on our net income and the carrying value of our assets.  We believe our tax assets and liabilities are adequate and are properly recorded in the condensed consolidated financial statements at September 30, 2011.

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Results of Operations for the Three and Nine Months Ended September 30, 2011 and 2010

Performance Overview

The following table provides selected financial information and performance information for the three and nine months ended September 30, 2011 and September 30, 2010.

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	(Dollars in thousands)
Net income	$	394		$	863		$	2,099		$	2,542
Diluted earnings per share		.04			.08			.20			.24
Pre-tax, pre-provision earnings, as adjusted (1)		2,690			2,288			6,716			7,961
Return on average assets (2)		.14	%		.31	%		.25	%		.31	%
Return on average equity (2)		1.34			3.03			2.44			3.03
Average interest-earning assets	$	1,036,064		$	997,279		$	1,025,231		$	989,290
Net interest income		8,859			8,886			26,903			27,658
Net interest margin		3.39	%		3.54	%		3.51	%		3.74	%
Non-interest income	$	3,310		$	2,127		$	10,299		$	6,911
Non-interest expense		9,186			9,437			30,224			28,500
Efficiency ratio (3)		80.50	%		85.70	%		84.54	%		83.56	%
______________
(1) See “Non-U.S. GAAP Financial Information” on page 43.
(2) Annualized.
(3) The efficiency ratio is calculated by dividing non-interest expense by the sum of net interest income and non-interest income, excluding net gain on sales of investment securities.

	September 30, 2011			December 31, 2010			September 30, 2010
Book value per share	$	10.55		$	10.41		$	10.49
Shareholders’ equity to total assets		9.82	%		10.07	%		10.17	%
Tangible capital ratio (Bank only)		8.87			9.07			8.91
Core capital ratio (Bank only)		8.87			9.07			8.91
Risk based capital ratio (Bank only)		13.57			13.32			13.21

The following discussion and analysis presents the more significant factors affecting our financial condition as of September 30, 2011 and results of operations for the three and nine months ended September 30, 2011.  This discussion and analysis should be read in conjunction with our condensed consolidated financial statements and notes thereto included in this report.

During the third quarter of 2011, we recorded net income of $394,000, or $.04 per diluted share, which represents our eighth consecutive quarter of positive earnings.  Our earnings included pre-tax gains on the sale of investment securities totaling $758,000 and $266,000 on the sale of other real estate owned which was offset by a $2.7 million provision for loan losses.

Our net interest margin decreased 15 basis points to 3.39% for the third quarter of 2011 from 3.54% for the third quarter of 2010.  Our net interest margin continued to be negatively impacted by our higher levels of liquidity due to strong deposit growth, modest loan demand, elevated levels of non-performing assets, and larger investment securities portfolio.  These factors resulted in a 44 basis point decline in our yield on average

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interest-earning assets, which was partially offset by a 32 basis point decrease in the cost of interest-bearing liabilities from the third quarter of 2010.

Improving credit quality remains a priority in 2011.  Our loan portfolio mix continues to improve as the higher risk, targeted contraction portfolios of commercial construction and land development and commercial participations decreased $5.2 million during the quarter.  Our total loans receivable decreased during the third quarter of 2011 by $12.0 million due to loan payoffs and repayments, charge-offs, and transfers to other real estate owned.

Our non-performing loans increased 3.7% to $59.3 million at September 30, 2011 compared to $57.2 million at June 30, 2011.  Non-performing loans during the third quarter increased primarily due to the transfer to non-accrual status of four commercial real estate non-owner occupied loans totaling $6.1 million.  The increase was partially offset by $2.5 million of charge-offs during the third quarter, a $771,000 payoff of an owner occupied commercial real estate loan due to the sale of the collateral, and the transfer to other real estate owned of a $979,000 owner occupied commercial real estate loan and a $1.9 million commercial participation loan.

During the third quarter of 2011, we sold our largest other real estate owned parcel that was carried at $6.7 million for a small gain.  In addition, we currently have contracts on six separate other real estate owned properties which we anticipate will reduce non-performing assets by an additional $597,000 during the fourth quarter of 2011 with no anticipated loss on sale, presuming the transactions close as scheduled and pursuant to the contractual terms.

We continue to have success in growing core deposits through many channels including enhancing our brand recognition within our communities, offering attractive deposit products, bringing in new client relationships by meeting all of their banking needs, and holding our experienced sales team accountable for growing deposits and relationships.  During 2011, we increased our core deposits by $57.4 million, or 10.6%, and core deposits represent 60.5% of total deposits compared to 57.0% at December 31, 2010.  Total deposits increased by $40.6 million, or 4.3%, from December 31, 2010 and by $56.6 million, or 6.1%, from September 30, 2010.

Our tangible, core, and risk-based capital ratios exceeded “minimum” and “well capitalized” for regulatory capital requirements.  Our tangible common equity at September 30, 2011 was $114.8 million, or 9.82% of tangible assets compared to $112.9 million, or 10.07% of tangible assets, at December 31, 2010.

Progress on Strategic Growth and Diversification Plan

We continue to focus our efforts on reducing the level of non-performing loans, seeking to either restructure specific non-performing credits or foreclose, obtain title, and transfer the loan to other real estate owned where we can take control of and liquidate the underlying collateral.  Our ratio of non-performing loans to total loans increased to 8.18% at September 30, 2011 compared to 7.76% at June 30, 2011 and 7.44% at December 31, 2010, which was related to an increase in non-accruing non-owner occupied commercial real estate loans and partially offset by transfers to other real estate owned during the quarter.  The non-performing assets ratio to total assets declined to 6.55% at September 30, 2011 from 6.95% at June 30, 2011 primarily due to the reduction in other real estate owned and the impact of a larger balance sheet.  For more information, see “Asset Quality” below in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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During the third quarter, we sold $6.9 million of other real estate owned, recognizing pre-tax net gains on the sales of $266,000.  We currently have contracts on six separate other real estate owned properties which will reduce non-performing assets by an additional $597,000 during the fourth quarter of 2011 with no anticipated loss on sale, presuming the transactions close as scheduled and pursuant to the contractual terms.

We remain strongly focused on our cost structure, as non-interest expense for the third quarter of 2011 decreased to $9.2 million from $11.1 million for the second quarter of 2011 and from $9.4 million for the third quarter of 2010.  The decrease was primarily the result of the absence of large valuation allowances on other real estate owned recognized in the second quarter of 2011.  Excluding these valuation allowances, non-interest expense for the third quarter decreased to $8.9 million from $9.3 million for the second quarter of 2011 and $9.2 million for the third quarter of 2010.

We continue to target specific segments in our loan portfolio, including commercial and industrial, commercial real estate – owner occupied, and multifamily, which in the aggregate comprised 52.2% of our commercial loan portfolio at September 30, 2011, compared to 53.1% at June 30, 2011 and 50.7% at December 31, 2010.  During the third quarter of 2011, a $6.8 million multifamily loan paid off which was partially offset by the origination of a $5.2 million non-owner occupied commercial real estate loan.  Our focus on deepening relationships continues to emphasize core deposit and relationship-oriented time deposit growth which resulted in a $40.6 million increase, or 4.3%, in deposits since December 31, 2010.

Non-U.S. GAAP Financial Information

Our accounting and reporting policies conform to U.S. GAAP and general practice within the banking industry.  Management uses certain non-U.S. GAAP financial measures to evaluate our financial performance and has provided the non-U.S. GAAP financial measures of pre-tax, pre-provision earnings, as adjusted, and pre-tax, pre-provision earnings, as adjusted, to average assets.  In these non-U.S. GAAP financial measures, the provision for loan losses, other real estate owned related income and expense, loan collection expense, and certain other items, such as gains and losses on sales of investment securities and other assets, and severance and early retirement expense, are excluded.  Management believes that these measures are useful because they provide a more comparable basis for evaluating financial performance excluding certain credit-related costs and other non-recurring items period to period and allows management and others to assess our ability to generate pre-tax earnings to cover our provision for loan losses and other credit-related costs.  Although these non-U.S. GAAP financial measures are intended to enhance investors understanding of our business performance, these operating measures should not be considered as an alternative to U.S. GAAP.

The risks associated with utilizing operating measures (such as the pre-tax, pre-provision earnings, as adjusted) are that various persons might disagree as to the appropriateness of items included or excluded in these measures and that other companies might calculate these measures differently.  Management compensates for these limitations by providing detailed reconciliations between U.S. GAAP information and our pre-tax, pre-provision earnings, as adjusted, as noted above; however, these disclosures should not be considered an alternative to U.S. GAAP.

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The following table reconciles income before income taxes in accordance with U.S. generally accepted accounting principles (U.S. GAAP) to the non-U.S. GAAP measurement of pre-tax, pre-provision earnings, as adjusted.

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	(Dollars in thousands)
Reconciliation of Income Before Income Taxes to Pre-Tax,   Pre-Provision Earnings, as adjusted:
Income before income taxes	$	310		$	1,051		$	2,406		$	3,017
Provision for loan losses		2,673			525			4,572			3,052
Pre-tax, pre-provision earnings		2,983			1,576			6,978			6,069
Add back (subtract):
Net gain on sale of:
Investment securities		(758	)		—			(1,450	)		(456	)
Other real estate owned		(266	)		(2	)		(2,499	)		(14	)
Other real estate owned related expense, net		614			470			3,217			1,356
Loan collection expense		117			156			470			478
Severance and early retirement expense		—			88			—			528
Pre-tax, pre-provision earnings, as adjusted	$	2,690		$	2,288		$	6,716		$	7,961
Pre-tax, pre-provision earnings, as adjusted, to average assets		.93	%		.82	%		.79	%		.97	%

Our pre-tax, pre-provision earnings, as adjusted, totaled $2.7 million for the third quarter of 2011 compared to $2.3 million for the third quarter of 2010.  The pre-tax, pre-provision earnings, as adjusted, for the third quarter of 2011 compared to the 2010 period was positively impacted by gains on the sale of loans receivable, increased card-based fees and commission income, and reduced FDIC insurance premiums and regulatory assessments and professional fees.

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Average Balances/Rates

The following tables reflect the average yield on assets and average cost of liabilities for the periods indicated.  Average balances are derived from average daily balances.

	Three Months Ended September 30,
	2011							2010
	Average				Average			Average				Average
	Balance		Interest		Yield/Cost			Balance		Interest		Yield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	730,524	$	8,881		4.82	%	$	744,316	$	9,199		4.90	%
Investment securities (2)		239,655		1,794		2.93			216,393		2,176		3.93
Other interest-earning assets (3)		65,885		80		.48			36,570		90		.98
Total interest-earning assets		1,036,064		10,755		4.12			997,279		11,465		4.56
Non-interest earning assets		114,085							114,363
Total assets	$	1,150,149						$	1,111,642
Interest-bearing liabilities:
Deposits:
Checking accounts	$	161,854		96		.24		$	145,471		120		.33
Money market accounts		187,523		190		.40			159,445		245		.61
Savings accounts		130,985		66		.20			120,486		80		.26
Certificates of deposit		391,275		1,250		1.27			404,586		1,698		1.67
Total deposits		871,637		1,602		.73			829,988		2,143		1.02
Borrowed funds:
Other short-term borrowed funds		15,562		15		.38			14,122		19		.53
FHLB advances		34,850		279		3.13			55,572		417		2.94
Total borrowed funds		50,412		294		2.28			69,694		436		2.45
Total interest-bearing liabilities		922,049		1,896		.82			899,682		2,579		1.14
Non-interest bearing deposits		100,849							87,654
Non-interest bearing liabilities		10,843							11,161
Total liabilities		1,033,741							998,497
Shareholders’ equity		116,408							113,145
Total liabilities and shareholders’ equity	$	1,150,149						$	1,111,642
Net interest-earning assets	$	114,015						$	97,597
Net interest income / interest rate spread			$	8,859		3.30	%			$	8,886		3.42	%
Net interest margin						3.39	%						3.54	%
Ratio of average interest-earning assets to
average interest-bearing liabilities						112.37	%						110.85	%

           ____________________

(1)	The average balance of loans receivable includes loans held for sale and non-performing loans, interest on which is recognized on a cash basis.
(2)	Average balances of investment securities are based on amortized cost.
(3)	Includes FHLB stock and interest-earning bank deposits.

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	Nine Months Ended September 30,
	2011							2010
	Average				Average			Average				Average
	Balance		Interest		Yield/Cost			Balance		Interest		Yield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)	$	730,242	$	26,708		4.89	%	$	754,145	$	28,503		5.05	%
Investment securities (2)		248,905		5,879		3.11			204,392		6,552		4.23
Other interest-earning assets (3)		46,084		401		1.16			30,753		337		1.47
Total interest-earning assets		1,025,231		32,988		4.30			989,290		35,392		4.78
Non-interest earning assets		115,560							105,755
Total assets	$	1,140,791						$	1,095,045
Interest-bearing liabilities:
Deposits:
Checking accounts	$	159,993		315		.26		$	144,661		240		.22
Money market accounts		186,769		666		.48			149,519		750		.67
Savings accounts		127,922		214		.22			118,243		273		.31
Certificates of deposit		398,228		4,077		1.37			389,824		5,079		1.74
Total deposits		872,912		5,272		.81			802,247		6,342		1.06
Borrowed funds:
Other short-term borrowed funds		14,385		48		.45			14,823		56		.51
FHLB advances		28,573		765		3.53			65,190		1,336		2.70
Total borrowed funds		42,958		813		2.50			80,013		1,392		2.29
Total interest-bearing liabilities		915,870		6,085		.89			882,260		7,734		1.17
Non-interest bearing deposits		98,815							90,041
Non-interest bearing liabilities		10,907							10,683
Total liabilities		1,025,592							982,984
Shareholders’ equity		115,199							112,061
Total liabilities and shareholders’ equity	$	1,140,791						$	1,095,045
Net interest-earning assets	$	109,361						$	107,030
Net interest income / interest rate spread			$	26,903		3.41	%			$	27,658		3.61	%
Net interest margin						3.51	%						3.74	%
Ratio of average interest-earning assets to
average interest-bearing liabilities						111.94	%						112.13	%

    ____________________

(1)	The average balance of loans receivable includes loans held for sale and non-performing loans, interest on which is recognized on a cash basis.
(2)	Average balances of investment securities are based on amortized cost.
(3)	Includes FHLB stock and interest-earning bank deposits.

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Rate/Volume Analysis

The following tables show the impact of changes in the volume of interest-earning assets and interest-bearing liabilities and changes in interest rates on our interest income and interest expense for the periods indicated.  Changes attributable to the combined impact of rate and volume have been allocated proportional to the changes due to rate and changes due to volume.

	Three Months Ended September 30,									Nine Months Ended September 30,
	2011 Compared to 2010									2011 Compared to 2010
	Change			Change						Change			Change
	due to			due to			Total			due to			due to			Total
	Rate			Volume			Change			Rate			Volume			Change
	(Dollars in thousands)
Interest income:
Loans receivable	$	(150	)	$	(168	)	$	(318	)	$	(906	)	$	(889	)	$	(1,795	)
Investment securities		(598	)		216			(382	)		(1,930	)		1,257			(673	)
Other interest-earning assets		(59	)		49			(10	)		(79	)		143			64
Total		(807	)		97			(710	)		(2,915	)		511			(2,404	)
Interest expense:
Deposits:
Checking accounts		(37	)		13			(24	)		48			27			75
Money market accounts		(93	)		38			(55	)		(246	)		162			(84	)
Savings accounts		(20	)		6			(14	)		(80	)		21			(59	)
Certificates of deposit		(394	)		(54	)		(448	)		(1,109	)		107			(1,002	)
Total deposits		(544	)		3			(541	)		(1,387	)		317			(1,070	)
Borrowed funds:
Other short-term borrowed funds		(6	)		2			(4	)		(6	)		(2	)		(8	)
FHLB advances		26			(164	)		(138	)		328			(899	)		(571	)
Total borrowed funds		20			(162	)		(142	)		322			(901	)		(579	)
Total		(524	)		(159	)		(683	)		(1,065	)		(584	)		(1,649	)
Net change in net interest income	$	(283	)	$	256		$	(27	)	$	(1,850	)	$	1,095		$	(755	)

Net Interest Income

Net Interest Income.Netinterest income was stable at $8.9 million for the three months ended September 30, 2011 and 2010.  Netinterest income totaled $26.9 million for the nine months ended September 30, 2011 compared to $27.7 million for the nine months ended September 30, 2010.  Thenet interest margin for the three months ended September 30, 2011 decreased 15 basis points to 3.39% from 3.54% for the comparable 2010 period and for the nine months ended September 30, 2011 decreased 23 basis points to 3.51% from 3.74% for the 2010 period.  Net interest income and the net interest margin continued to be negatively impacted by our higher levels of liquidity due to strong deposit growth, modest loan demand, our elevated level of non-performing assets, and larger investment securities portfolio.

Interest Income.  Interest income decreased to $10.8 million for the three months ended September 30, 2011 compared to $11.5 million for the comparable 2010 period.  For the nine months ended September 30, 2011, interest income decreased to $33.0 million from $35.4 million for the 2010 period.  The weighted-average rate on interest-earning asset decreased to 4.12% and 4.30% for the three and nine months ended September 30, 2011, respectively, from 4.56% and 4.78% for the comparable 2010 periods.  The decrease was primarily due to higher average balances of investment securities, lower average balances of loans receivable, and the current lower interest rate environment which reduced the yields on loans receivable and investment securities.  The

46

yield on loans receivable decreased due to a reduction in interest income related to the higher level of non-accrual loans.  The yield on investment securities declined due to reinvesting maturing investment securities in lower yielding investments as market interest rates remained significantly low.  In addition, during 2011 the Bank was holding higher levels of short-term liquid investments due to the lack of desirable investment alternatives in the current interest rate environment.

           Interest Expense.  Interest expense decreased to $1.9 million for the three months ended September 30, 2011 from $2.6 million for the 2010 period.  The average cost of interest-bearing liabilities decreased 32 basis points to .82% for the three months ended September 30, 2011 from 1.14% for the prior year quarter.  For the nine months ended September 30, 2011, interest expense decreased to $6.1 million from $7.7 million for the 2010 period.  The average cost of interest-bearing liabilities decreased 28 basis points to .89% for the nine months ended September 30, 2011 from 1.17% for the 2010 period.  Interest expense continues to be positively affected by strong growth in low-cost core deposit balances and a reduction in higher cost certificates of deposit and FHLB advances.

 Interest expense on interest-earning deposits decreased to $1.6 million and $5.3 million, respectively, for the three and nine month periods ended September 30, 2011 from $2.1 million and $6.3 million, respectively, for the comparable 2010 periods.  The weighted-average cost of deposits decreased 29 and 25 basis points to .73% and .81%, respectively, for the three and nine month periods ended September 30, 2011 from 1.02% and 1.06% for the comparable 2010 periods as a result of disciplined pricing on deposits, the repricing of certificates of deposit at lower interest rates, and increases in the average balance of non-interest bearing deposits, which was partially offset by increases in the average balance of interest bearing deposits.

 Interest expense on borrowed funds decreased to $294,000 and $813,000, respectively, for the three and nine months ended September 30, 2011 from $436,000 and $1.4 million, respectively, for the 2010 periods primarily as a result of significant reductions in the average balance of borrowed funds during the 2011 periods compared to the 2010 periods as we continue to strengthen our balance sheet and enhance our liquidity position by replacing this higher cost funding source with core deposits.  The weighted-average cost of borrowed funds decreased 17 basis points during the three months ended September 30, 2011 to 2.28% from 2.45% for the same period 2010 and was primarily the result of a new $15.0 million four-year fixed-rate FHLB advance.  The weighted-average cost of borrowed funds increased 21 basis points during the nine months ended September 30, 2011 to 2.50% from 2.29% for the same period 2010.

Provision for Loan Losses

The Company’s provision for loan losses was $2.7 million for the three months ended September 30, 2011 compared to $525,000 for the 2010 period.  The Company’s provision for loan losses was $4.6 million compared to $3.1 million, respectively, for the nine months ended September 30, 2011 and 2010.  For more information, see “Changes in Financial Condition – Allowance for Loan Losses” below in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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Non-Interest Income

The following table identifies the changes in non-interest income for the period presented:

	Three Months Ended September 30,
	2011		2010		$ Change			% Change
		(Dollars in thousands)
Service charges and other fees	$	1,263	$	1,290	$	(27	)		(2.1	)%
Card-based fees		520		475		45			9.5
Commission income		100		40		60			150.0
Subtotal fee based revenues		1,883		1,805		78			4.3
Income from bank-owned life insurance		216		217		(1	)		(.5	)
Other income		121		103		18			17.5
Subtotal		2,220		2,125		95			4.5
Net gain on sale of:
Investment securities		758		—		758			NM
Loans receivable		66		—		66			NM
Other real estate owned		266		2		264			NM
Total non-interest income	$	3,310	$	2,127	$	1,183			55.6	%

	Nine Months Ended September 30,
	2011		2010		$ Change			% Change
		(Dollars in thousands)
Service charges and other fees	$	3,513	$	3,830	$	(317	)		(8.3	)%
Card-based fees		1,515		1,398		117			8.4
Commission income		223		140		83			59.3
Subtotal fee based revenues		5,251		5,368		(117	)		(2.2	)
Income from bank-owned life insurance		632		702		(70	)		(10.0	)
Other income		343		371		(28	)		(7.5	)
Subtotal		6,226		6,441		(215	)		(3.3	)
Net gain on sale of:
Investment securities		1,450		456		994			218.0
Loans receivable		124		—		124			NM
Other real estate owned		2,499		14		2,485			NM
Total non-interest income	$	10,299	$	6,911	$	3,388			49.0	%

 Service charges and other fees were impacted by a lower volume of non-sufficient funds transactions which is an industry trend that is expected to continue due to regulatory changes affecting deposit account overdraft activity.  Service charges and other fees were also impacted by lower credit enhancement fee income related to non-owner occupied commercial real estate letters of credit as we continue to strategically reduce our exposure to these types of relationships.  Higher card-based fees and commission income were partially offset by lower income from bank-owned life insurance and other income.  The $264,000 increase in net gain on the sale of other real estate owned for the quarter ended September 30, 2011 was primarily due to a small gain recognized on the sale of our largest commercial property carried at $6.7 million.  For information related to net gains on sale of investment securities, see “Changes in Financial Condition – Investment Securities” below in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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Non-Interest Expense

The following table identifies changes in our non-interest expense for the period presented:

	Three Months Ended September 30,
	2011		2010		$ Change			% Change
		(Dollars in thousands)
Compensation and mandatory benefits	$	4,243	$	4,239	$	4			.1	%
Retirement and stock related compensation		198		176		22			12.5
Medical and life benefits		365		285		80			28.1
Other employee benefits		12		9		3			33.3
Subtotal compensation and employee benefits		4,818		4,709		109			2.3
Net occupancy expense		706		691		15			2.2
FDIC insurance premiums and regulatory assessments		481		623		(142	)		(22.8	)
Professional fees		309		512		(203	)		(39.6	)
Furniture and equipment expense		436		488		(52	)		(10.7	)
Data processing		424		443		(19	)		(4.3	)
Marketing		213		189		24			12.7
Other real estate owned related expense, net		614		470		144			30.6
Loan collection expense		117		156		(39	)		(25.0	)
Severance and early retirement expense		—		88		(88	)		(100.0	)
Other general and administrative expenses		1,068		1,068		—			—
Total non-interest expense	$	9,186	$	9,437	$	(251	)		(2.7	)%

	Nine Months Ended September 30,
	2011			2010	$ Change			% Change
		(Dollars in thousands)
Compensation and mandatory benefits	$	12,906	$	12,414	$	492			4.0	%
Retirement and stock related compensation		627		565		62			11.0
Medical and life benefits		1,532		910		622			68.4
Other employee benefits		39		39		—			—
Subtotal compensation and employee benefits		15,104		13,928		1,176			8.4
Net occupancy expense		2,141		2,097		44			2.1
FDIC insurance premiums and regulatory assessments		1,638		1,891		(253	)		(13.4	)
Professional fees		1,031		1,850		(819	)		(44.3	)
Furniture and equipment expense		1,353		1,547		(194	)		(12.5	)
Data processing		1,307		1,316		(9	)		(.7	)
Marketing		670		519		151			29.1
Other real estate owned related expense, net		3,217		1,356		1,861			137.2
Loan collection expense		470		478		(8	)		(1.7	)
Severance and early retirement expense		—		528		(528	)		(100.0	)
Other general and administrative expenses		3,293		2,990		303			10.1
Total non-interest expense	$	30,224	$	28,500	$	1,724			6.0	%

 Compensation and employee benefits increased $109,000 and $1.2 million, respectively, for the three and nine months ended September 30, 2011 from the 2010 periods.  The increase was primarily a result of an increase in compensation and mandatory benefits expense due to normal salary adjustments coupled with an increase in estimated incentive accruals.  Medical and life benefits increased due to significantly higher medical claims incurred during 2011.

FDIC insurance premiums and regulatory assessments expense decreased $142,000 and $253,000, respectively, for the three and nine months ended September 30, 2011 from the 2010 periods due to the new FDIC premium assessment methodology.

49

 Professional fees decreased $203,000 and $819,000, respectively, for the three and nine months ended September 30, 2011 from the 2010 periods primarily due to lower legal, strategic advisor, and investor relations fees, the absence of costs during 2011 relating to the 2010 annual meeting proxy contest, and decreased costs related to the SEC’s 2010 proxy statement disclosures.

Other real estate owned related expense, net, increased during the 2011 periods due to the establishment of valuation allowances totaling $2.1 million related to other real estate owned properties.

Income Tax Expense

Income tax benefit for the three months ended September 30, 2011 totaled $84,000, equal to an effective tax benefit rate of 27.1% compared to an effective tax rate of 17.9% for the third quarter of 2010.   Income tax expense for the nine months ended September 30, 2011 totaled $307,000, equal to an effective tax rate of 12.8% compared to an effective tax rate of 15.7% for the 2010 period.  The decrease in the effective income tax rate during the 2011 periods was due to the increased tax sheltering impact of income from bank-owned life insurance and other tax credits.

Changes in Financial Condition

Our total assets increased to $1.17 billion at September 30, 2011 from $1.12 billion at December 31, 2010.

	September 30, 2011		December 31, 2010		$ Change			% Change
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	117,765	$	61,754	$	56,011			90.7	%
Investment securities available-for-sale, at fair value		218,417		197,101		21,316			10.8
Investment securities held-to-maturity, at cost		14,387		17,201		(2,814	)		(16.4	)
Federal Home Loan Bank stock, at cost		8,638		20,282		(11,644	)		(57.4	)
Loans receivable, net		708,281		715,405		(7,124	)		(1.0	)
Bank-owned life insurance		36,095		35,463		632			1.8
Other real estate owned		17,195		22,324		(5,129.129	)		(23.0	)
Other assets		47,703		52,146		(4,443	)		(8.5	)
Total assets	$	1,168,481	$	1,121,676	$	46,805			4.2	%
Liabilities and Equity:
Deposits	$	986,441	$	945,884	$	40,557			4.3	%
Borrowed funds		56,115		53,550		2,565			4.8
Other liabilities		11,170		9,314		1,856			19.9
Total liabilities		1,053,726		1,008,748		44,978			4.5
Shareholders’ equity		114,755		112,928		1,827			1.6
Total liabilities and equity	$	1,168,481	$	1,121,676	$	46,805			4.2	%

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Loans Receivable

The following table provides the balance and the percentage of loans by category at the dates indicated.

	September 30, 2011						December 31, 2010
	Amount			% of Total			Amount			% of Total			% Change
	(Dollars in thousands)
Commercial loans:
Commercial and industrial	$	83,569			11.5	%	$	74,940			10.3	%		11.5	%
Commercial real estate:
Owner occupied		100,244			13.8			99,435			13.6			.8
Non-owner occupied		193,267			26.7			191,998			26.2			.7
Multifamily		70,129			9.7			72,080			9.8			(2.7	)
Commercial construction and land development		22,635			3.1			24,310			3.3			(6.9	)
Commercial participations		16,739			2.3			23,594			3.2			(29.1	)
Total commercial loans		486,583			67.1			486,357			66.4			—
Retail loans:
One-to-four family residential		181,025			25.0			185,321			25.3			(2.3	)
Home equity lines of credit		53,953			7.4			56,177			7.7			(4.0	)
Retail construction		1,299			.2			3,176			.4			(59.1	)
Other		3,007			.4			2,122			.3			41.7
Total retail loans		239,284			33.0			246,796			33.7			(3.0	)
Total loans receivable		725,867			100.1			733,153			100.1			(1.0	)
Net deferred loan fees		(400	)		(.1	)		(569	)		(.1	)		(29.7	)
Total loans receivable, net of deferred loan fees	$	725,467			100.0	%	$	732,584			100.0	%		(1.0	)%

At September 30, 2011, the net loan portfolio included $159.3 million of variable-rate loans indexed to the prime lending rate as listed in the Wall Street Journal and $206.2 million of loans tied to other indices that reprice at various intervals from one month up to five years.

Loan fundings during the nine months ended September 30, 2011 totaled $65.4 million compared to loan fundings of $46.2 million for the nine months ended September 30, 2010, which reflects increased loan demand levels during the current year.  The Company’s business banking pipeline continues to improve.  Loan fundings in 2011 were partially offset by loan payoffs and repayments of $55.1 million, transfers to other real estate owned totaling $6.8 million, and gross charge-offs of $4.6 million.

Through the execution of our Strategic Growth and Diversification Plan, we continue to diversify our loan portfolio and reduce loans not meeting our current defined risk tolerance.  Our targeted growth segments within the loan portfolio, including commercial and industrial, commercial real estate – owner occupied, and multifamily commercial real estate, comprise 52.2% of the commercial loan portfolio at September 30, 2011.

Commercial participations decreased 29.1% compared to December 31, 2010 through net paydowns totaling $1.4 million and charge-offs totaling $1.4 million.  In addition, we sold $2.1 million of a participation to another participant and transferred another participation totaling $1.9 million to other real estate owned.  Total commercial participations by loan type and state are presented in the following tables as of the dates indicated.

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	September 30, 2011					December 31, 2010
	Amount		% of Total			Amount		% of Total			% Change
	(Dollars in thousands)
Commercial and industrial	$	177		1.1	%	$	226		1.0	%		(21.7	)%
Commercial real estate:
Owner occupied		103		.6			83		.3			24.1
Non-owner occupied		15,319		91.5			19,064		80.8			(19.6	)
Commercial construction and land development		1,140		6.8			4,221		17.9			(73.0	)
Total commercial participations	$	16,739		100.0	%	$	23,594		100.0	%		(29.1	)%

	September 30, 2011					December 31, 2010
	Amount		% of Total			Amount		% of Total			% Change
	(Dollars in thousands)
Illinois	$	1,844		11.0	%	$	4,988		21.1	%		(63.0	)%
Indiana		5,759		34.4			5,774		24.5			(.3	)
Ohio		4,951		29.6			7,332		31.1			(32.5	)
Florida		1,140		6.8			1,843		7.8			(38.1	)
Colorado		1,525		9.1			2,075		8.8			(26.5	)
Texas		1,520		9.1			1,582		6.7			(3.9	)
Total commercial participations	$	16,739		100.0	%	$	23,594		100.0	%		(29.1	)%

Investment Securities

 We manage our investment securities portfolio to adjust balance sheet interest rate sensitivity to insulate net interest income against the impact of changes in market interest rates, to maximize the return on invested funds within acceptable risk guidelines, and to meet pledging and liquidity requirements.

 We adjust the size and composition of our investment securities portfolio according to a number of factors including expected loan and deposit growth, the interest rate environment, and projected liquidity.  The amortized cost of investment securities available-for-sale and their fair values were as follows at the dates indicated:

					Gross		Gross
	Par		Amortized		Unrealized		Unrealized			Fair
	Value		Cost		Gains		Losses			Value
	(Dollars in thousands)
At September 30, 2011:
U.S. Treasury securities	$	15,000	$	14,969	$	436	$	—		$	15,405
Government sponsored entity (GSE)     securities		51,800		51,923		1,665		—			53,588
Corporate bonds		4,000		3,677		66		—			3,743
Collateralized mortgage obligations		56,825		50,978		1,258		(1,088	)		51,148
Commercial mortgage-backed securities		74,892		76,646		1,114		(236	)		77,524
Pooled trust preferred securities		27,910		25,220		—		(8,215	)		17,005
GSE preferred stock		200		—		4		—			4
	$	230,627	$	223,413	$	4,543	$	(9,539	)	$	218,417

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					Gross		Gross
	Par		Amortized		Unrealized		Unrealized			Fair
	Value		Cost		Gains		Losses			Value
	(Dollars in thousands)
At December 31, 2010:
U.S. Treasury securities	$	15,000	$	14,975	$	3	$	(159	)	$	14,819
Government sponsored entity (GSE)     securities		30,800		30,717		421		(118	)		31,020
Corporate bonds		4,000		3,629		—		(43	)		3,586
Collateralized mortgage obligations		62,512		59,037		2,071		(353	)		60,755
Commercial mortgage-backed securities		66,282		67,052		1,804		(158	)		68,698
Pooled trust preferred securities		29,409		26,473		—		(8,348	)		18,125
GSE preferred stock		5,837		—		98		—			98
	$	213,840	$	201,883	$	4,397	$	(9,179	)	$	197,101

 The fair value of investment securities available-for-sale totaled $218.4 million at September 30, 2011 compared to $197.1 million at December 31, 2010.  Our investment securities portfolio increased since December 31, 2010 due to investing the proceeds from both our deposit growth and redemption of Federal Home Loan Bank Stock as the demand for loans remains constrained by our local economic conditions.

At September 30, 2011, our collateralized mortgage obligation portfolio totaled $51.1 million, with 97% of the portfolio maintaining a credit rating of A or better.  The portfolio is mainly backed by conventional residential mortgages with prime loans originated prior to 2005, low historical delinquencies, and weighted-average credit scores in excess of 725.  Of our collateralized mortgage obligation portfolio, $26.4 million consists of floating-rate bonds with unaccreted discounts totaling $5.5 million.  The composition of this portfolio includes $5.7 million backed by Ginnie Mae.

Our commercial mortgage-backed investment securities portfolio consists mainly of senior tranches of issues originated prior to 2006 with extensive subordination and limited balloon risk.  All bonds were AAA-rated at September 30, 2011.  On July 15, 2011, a $2.9 million bond was placed on watch for downgrade due to 41% of the collateral having been previously defeased, or replaced with U.S. Treasury securities.  Subsequent to September 30, 2011, this bond was removed from watch and rated AAA.

Our corporate bond portfolio consists of a single AA-rated, floating-rate note purchased at a large discount and maturing in 2016.

At September 30, 2011, in management’s belief, the unrealized losses in the our investment securities portfolio are primarily attributable to macroeconomic conditions affecting the liquidity of these securities and not necessarily the expected cash flows of the individual securities.  The fair value of these securities is expected to recover as the economy recovers, as interest rates rise, and as the performance of the underlying collateral improves.

All of our pooled trust preferred investments were AAA-rated when they were purchased at discounts in excess of 10%.  In 2009, the market for this type of investment was severely impacted by the credit crisis leading to increased deferrals and defaults.  Credit ratings were also negatively affected in 2009, and all of these securities in our portfolio have at least one rating below investment grade.  One tranche with an amortized cost of $7.1 million holds recently updated ratings of both A and CCC-.  

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We utilize extensive external and internal analysis on the pooled trust preferred holdings.  Our internal model stress tests all underlying issuers in the pools to project probabilities of deferral or default.  Management’s internal modeling runs multiple stress scenarios.  The high-stress scenario utilizes immediate defaults for all deferring collateral.  Any collateral that management believes may be at risk for deferring or defaulting, based upon management’s review of the underlying issuers’ most recent financial and regulatory information, is assumed to default immediately.  Despite a recent trend of recoveries from previously defaulted trust preferred collateral, the high stress scenario assumes no recoveries on defaulted collateral.  All external and internal stress testing currently projects no loss of principal or interest on any of our pooled trust preferred holdings.

All of our pooled trust preferred holdings are Super Senior tranches and were purchased at large discounts.  The Super Senior tranches are the most senior tranches.  Due to the structure of the securities, as deferrals and defaults on the underlying collateral increase, cash flows are increasingly diverted from mezzanine and subordinate tranches to pay down principal on the Super Senior tranches.  If certain senior coverage tests are not met, all interest is diverted from subordinate classes to pay down principal on the Super Senior tranche.  Four of the five issues owned by the Company are failing the senior coverage test.  This test is structured to protect the holders of the Super Senior tranches if deferrals or defaults exceed a specific threshold as a percent of the outstanding senior tranches.  As such, the proceeds of any early redemptions, successful tenders, or cures will be used to further pay down principal of the Super Senior tranches on these four issues.  Annualized principal pay down rates on the Company’s pooled trust preferred portfolio were 15.6% and 3.4% for the second and third quarter of 2011, respectively.  Based on the pace of and success of planned capital raises by underlying issuers and confirmed acquisition announcements of underlying issuers, the Company expects additional cure and redemption announcements in the near term.  During the third quarter, the percentage of original collateral backing the pools deemed at risk by the Company was stable.

An increasing number of previously deferring issuers are resuming payments.  Of the previously deferring issues, 6.9% “cured,” or resumed payments, in the second quarter of 2011 and an additional 5.1% cured in the third quarter of 2011.  When a previously deferring company cures, all past interest and accrued interest on the past due interest is paid to the trust.  Cures outpaced new deferrals in excess of 3:1 for the second quarter in a row.  New deferrals in the third quarter of 2011 were the lowest since prior to 2008 and totaled .2% of the original collateral.  For the past two quarters, redemptions have outpaced new deferrals at a pace of nearly 4:1.

The Company is expecting redemption activity to increase over the next year as call windows open on the remaining securities and issuers reevaluate the impact of Dodd-Frank changes to Tier 1 capital treatment of these securities for certain issuers and the high cost of this capital in the current low interest rate market.  The call window is open on two of the Bank’s five securities and the call windows on the other three securities will open over the next twelve months.

Failing senior coverage tests and past defaults ensure all redemption proceeds will be diverted to pay down the principal on our Super Senior tranches until coverage tests once again pass.  Four of the Company’s five issues have seen senior coverage ratios improve this year.  The fifth issue has seen a small level of deterioration, but it is the closest of the four failing issues to the passing threshold.

Cures, redemptions, and cash flows diverted from mezzanine tranches have combined to reduce the par balances on two of the Company’s issues with open call windows to below .80.  The Company’s largest original face value holding has factored down to below .75.

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Due to the current ratings on the pooled trust preferred securities being below investment grade, our investments in pooled trust preferred securities with an aggregate market value totaling $17.0 million are classified as substandard in accordance with regulatory requirements.

Deposits

The following table sets forth the dollar amount of deposits and the percentage of total deposits in each category offered at the dates indicated:

	September 30, 2011					December 31, 2010
	Amount		% of Total			Amount		% of Total			% Change
	(Dollars in thousands)
Checking accounts:
Non-interest bearing	$	106,476		10.8	%	$	90,315		9.5	%		17.9	%
Interest-bearing		172,007		17.4			149,948		15.9			14.7
Money market accounts		185,906		18.9			177,566		18.8			4.7
Savings accounts		132,378		13.4			121,504		12.8			8.9
Core deposits		596,767		60.5			539,333		57.0			10.6
Certificates of deposit accounts		389,674		39.5			406,551		43.0			(4.2	)
Total deposits	$	986,441		100.0	%	$	945,884		100.0	%		4.3	%

The Bank strives to grow deposits through many channels including enhancing its brand recognition within its communities, offering attractive deposit products, bringing in new client relationships by meeting all of their banking needs, and holding its experienced sales team accountable for growing deposits and relationships.  During 2011, we increased our core deposits by $57.4 million, including increases of $16.2 million in non-interest bearing checking deposits and $22.1 million in interest bearing checking deposits.  Increasing core deposits is reflective of our success in deepening our client relationships, one of our core Strategic Plan objectives.  Total certificates of deposit decreased by $16.9 million, or 4.2%, at September 30, 2011 compared to December 31, 2010 as management continues to be disciplined about pricing these deposits.

In addition, we offer a repurchase sweep agreement (Repo Sweep) account which allows public entities and other business depositors to earn interest with respect to checking and savings deposit products offered.  The depositor’s excess funds are swept from a deposit account and are used to purchase an interest in investment securities that we own.  The swept funds are not recorded as deposits and instead are classified as other short-term borrowed funds which generally provide a lower-cost funding alternative as compared to FHLB advances.  At September 30, 2011, we had $16.2 million in Repo Sweeps compared to $13.4 million at December 31, 2010.  The Repo Sweeps are included in the table under “Borrowed Funds” and are treated as financings, and the obligations to repurchase investment securities sold are reflected as short-term borrowed funds.  The investment securities underlying these Repo Sweeps continue to be reflected as assets.

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Borrowed Funds

Borrowed funds consisted of the following at the dates indicated:

	September 30, 2011					December 31, 2010
			Weighted-					Weighted-
			Average					Average
			Contractual					Contractual
	Amount		Rate			Amount		Rate
	(Dollars in thousands)
Advances from FHLB of Indianapolis:
Fixed rate advances due in:
2011	$	—		—	%	$	15,000		3.75	%
2013		15,000		2.22			15,000		2.22
2015		15,000		1.42			—		—
2014 (1)		1,069		6.71			1,096		6.71
2018 (1)		2,513		5.54			2,513		5.54
2019 (1)		6,358		6.29			6,589		6.30
Total FHLB advances		39,940		2.90			40,198		3.79
Short-term variable-rate borrowed funds - repo sweep accounts		16,175		.30			13,352		.50
Total borrowed funds	$	56,115		2.15	%	$	53,550		2.97	%

           ____________________

(1) These are amortizing advances and are listed by their contractual final maturity date.

During the third quarter of 2011, the Bank entered into a new $15.0 million four-year fixed-rate FHLB advance which was taken for interest rate risk purposes.

At September 30, 2011, the Bank had a line of credit with a large commercial bank with a maximum of $15.0 million in secured overnight federal funds availability at the federal funds market rate at the time of any borrowing.  The Bank also has a borrowing relationship with the Federal Reserve Bank (FRB) discount window.  There were no outstanding balances at September 30, 2011 and December 31, 2010.  These lines were not utilized during 2011.

Shareholders’ Equity

Shareholders’ equity at September 30, 2011 was $114.8 million compared to $112.9 million at December 31, 2010.  The increase was primarily due to $2.1 million of net income for the year to date period less common stock dividends declared of $328,000.

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Asset Quality and Allowance for Loan Losses

Non-performing Assets.The following table provides information relating to non-performing assets at the dates presented.

	September 30, 2011			June 30, 2011			December 31, 2010
	(Dollars in thousands)
Non-performing loans:
Commercial loans:
Commercial and industrial	$	571		$	665		$	228
Commercial real estate:
Owner occupied		12,296			14,852			9,119
Non-owner occupied		25,664			19,844			21,512
Multifamily		783			1,002			1,071
Commercial construction and land development		7,707			7,707			9,183
Commercial participations		6,442			8,191			9,499
Total commercial loans		53,463			52,261			50,612
Retail loans:
One-to-four family residential		4,908			4,194			2,955
Home equity lines of credit		795			589			718
Retail construction		169			169			203
Other		―			4			4
Total retail loans		5,872			4,956			3,880
Total non-performing loans		59,335			57,217			54,492
Other real estate owned, net		17,195			21,164			22,324
Total non-performing assets		76,530			78,381			76,816
90 days past due loans still accruing interest		96			405			2,469
Total non-performing assets plus 90 days past due
loans still accruing interest	$	76,626		$	78,786		$	79,285
Non-performing assets to total assets		6.55	%		6.95	%		6.85	%
Non-performing loans to total loans, net of deferred fees		8.18			7.76			7.44

Total non-performing loans increased $2.1 million to $59.3 million at September 30, 2011 from $57.2 million at June 30, 2011 and increased $4.8 million from $54.5 million at December 31, 2010.  During the third quarter of 2011, non-performing loans increased primarily due to four non-owner occupied commercial real estate loans totaling $6.1 million being transferred into non-accrual status.  Partially offsetting this increase, net charge-offs totaled $2.5 million during the third quarter of 2011.  Non-performing loans also decreased due to the payoff of a $771,000 owner occupied commercial real estate loan from the sale of the collateral and the transfers of an owner occupied commercial real estate loan totaling $979,000 and a commercial participation loan totaling $1.9 million being transferred to other real estate owned.

During the third quarter of 2011, the Bank sold $6.9 million of other real estate owned properties and recognized pre-tax net gains on the sales totaling $266,000.  We currently have contracts on six separate other real estate owned properties which we anticipate will reduce non-performing assets by an additional $597,000 during the fourth quarter of 2011 with no anticipated loss on sale, presuming the transactions close as scheduled and pursuant to the contractual terms.

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Included in the non-performing loan totals are non-performing syndications and purchased participations as identified by loan category and states in the following tables.

	September 30, 2011			June 30, 2011			December 31, 2010			% Change from December 31 to September 30
	(Dollars in thousands)
Commercial real estate – non-owner occupied	$	5,302		$	5,302		$	5,302			—	%
Commercial construction and land development		1,140			2,889			4,197			(72.8	)
Total non-performing syndications and           purchased participations	$	6,442		$	8,191		$	9,499			(32.2	)%
Illinois	$	—		$	1,749		$	2,354			(100.0	)%
Indiana		5,302			5,302			5,302			—
Florida		1,140			1,140			1,843			(38.1	)
Total non-performing syndications and          purchased participations	$	6,442		$	8,191		$	9,499			(32.2	)%
Percentage of total non-performing loans		10.9	%		14.3	%		17.4	%
Percentage of total syndications and purchased      participations		38.5			38.6			40.3

Potential Problem Assets.Potential problem assets, defined as loans classified substandard pursuant to our internal loan grading system that do not meet the definition of a non-performing loan, totaled $4.1 million at September 30, 2011 and $926,000 at December 31, 2010.

Allowance for Loan Losses.The following is a summary of changes in the allowance for loan losses for the periods presented:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	(Dollars in thousands)
Balance at beginning of period	$	17,039		$	17,608		$	17,179		$	19,461
Loan charge-offs		(2,556	)		(690	)		(4,643	)		(5,205	)
Recoveries of loans previously charged-off		30			42			78			177
Net loan charge-offs		(2,526	)		(648	)		(4,565	)		(5,028	)
Provision for loan losses		2,673			525			4,572			3,052
Balance at end of period	$	17,186		$	17,485		$	17,186		$	17,485

	September 30, 2011			December 31, 2010			September 30, 2010
	(Dollars in thousands)
Allowance for loan losses	$	17,186		$	17,179		$	17,485
Total loans receivable, net of unearned fees		725,467			732,584			724,137
Allowance for loan losses to total loans		2.37	%		2.34	%		2.41	%
Allowance for loan losses to non-performing loans		28.96			31.53			31.17

At December 31, 2010, we determined that a shorter credit loss history was more appropriate and indicative of the current inherent losses within our loan portfolio and consistent with current allowance trends in the banking industry.  Prior to December 31, 2010, the allowance for loan losses was calculated using a static four year historical net charge-off factor for each loan category.  In addition, the allowance for loan losses was

58

based on our regulatory reporting categories as opposed to loan type and did not segregate the commercial purchased participation loans into a separate loan and allowance for loss category.  Based on the nature of our purchased participation loans, we believe these loans have a higher degree of risk than the other loan categories due to the fact that we are not the lead lender, many of the purchased participations are outside of our market area, and the national and local economic conditions have impacted many of the projects collateralizing these participations.  We also had substantially modified our credit policy, underwriting standards, lending personnel, and lending strategy in 2007 and 2008.  In addition, in mid-2007, we ceased purchasing participation loans and substantially reduced the origination of commercial construction and land development loans.  As such, the balances in the purchased participation portfolio will continue to decrease, and we believe the significant losses incurred related to the purchased participation loans are not indicative of the losses inherent within the directly originated portfolio.  Segregation of these purchased participation loans as a separate loan category was appropriate at December 31, 2010.

Changing the allowance methodology to shorten the historical loss period and segregate the purchased participation loan portfolio resulted in a reduction in the historical loss factor percentages applied to most of the directly originated loan portfolio categories and a larger historical loss factor percentage applied to the purchased participation portfolio.  The net effect of these changes was a decrease in the provision and the allowance for loan losses at December 31, 2010 of $1.2 million.  The effect of the segregation of the purchased participation portfolio coupled with the decrease in the total loan balances from December 31, 2009 to December 31, 2010 decreased the allowance for loan losses for all non-participation loan categories by $1.9 million and the higher loss factors related to purchased participations increased the allowance for loan losses by $701,000.  The remaining decrease was primarily due to the decrease of $759,000 in the ASC 310-10 component on individually impaired loans to $8.4 million at December 31, 2010.

The allowance for loan losses was relatively stable at $17.2 million at September 30, 2011 compared to $17.2 million at December 31, 2010 and $17.5 million at September 30, 2010.  The ratio of the allowance for loan losses to total loans was also relatively stable at 2.37% at September 30, 2011 compared to 2.34% and 2.41%, respectively, at December 31, 2010 and September 30, 2010.

The provision for losses on loans increased to $2.7 million for the third quarter of 2011 from $525,000 for the prior year quarter.  The increase during the third quarter of 2011 was primarily related to the higher level of net charge-offs in the current quarter.  Net charge-offs included $532,000 on two commercial and industrial loan relationships, $876,000 on an owner occupied commercial real estate loan relationship, $448,000 on a non-owner occupied commercial real estate loan, and $360,000 on eight home equity lines of credit.

When we determine that a non-performing collateral dependent loan has a collateral shortfall, we will immediately charge off the collateral shortfall.  As a result, we are not required to maintain an allowance for loan losses on these loans as the loan balance has already been written down to its net realizable value (fair value less estimated costs to sell the collateral).  As such, the ratio of the allowance for loan losses to total loans and the ratio of the allowance for loan losses to non-performing loans have been affected by cumulative partial charge-offs of $4.2 million recorded through September 30, 2011 on $7.3 million, net of charge-offs, of collateral dependent non-performing loans and specific impairment reserves totaling $8.7 million on other non-collateral dependent non-performing loans at September 30, 2011.

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Liquidity and Capital Resources

Liquidity, represented by cash and cash equivalents, is a product of operating, investing, and financing activities.  Our primary sources of funds are:

• deposits and Repo Sweeps;

• scheduled payments of amortizing loans and mortgage-backed investment securities;

• prepayments and maturities of outstanding loans and mortgage-backed investment securities;

• maturities of investment securities and other short-term investments;

• funds provided from operations;

• federal funds line of credit; and

• borrowed funds from the FHLB and Federal Reserve Bank.

 The Asset/Liability Management Committee is responsible for measuring and monitoring our liquidity profile.  We manage our liquidity to ensure stable, reliable, and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals, and investment opportunities.  Our general approach to managing liquidity involves preparing a monthly “funding gap” report which forecasts cash inflows and cash outflows over various time horizons and rate scenarios to identify potential cash imbalances.  We supplement our funding gap report with the monitoring of several liquidity ratios to assist in identifying any trends that may have an effect on available liquidity in future periods.

We maintain a contingency funding plan that outlines the process for addressing a liquidity crisis.  The plan assigns specific roles and responsibilities for effectively managing liquidity through a problem period.

Scheduled payments from the amortization of loans, maturing investment securities, and short-term investments are relatively predictable sources of funds, while deposit flows and loan prepayments are greatly influenced by market interest rates, economic conditions, and competitive rate offerings.

At September 30, 2011, we had cash and cash equivalents of $117.8 million, an increase from $61.8 million at December 31, 2010.  The increase was mainly the result of:

• proceeds from sales, maturities, and paydowns of investment securities aggregating $84.0 million;

• increases in deposit accounts totaling $40.5 million;

• proceeds from the sale of other real estate owned totaling $13.4 million;

• proceeds from one fixed-rate FHLB advance totaling $15.0 million; and

• redemption of FHLB stock of $11.6 million.

The above cash inflows were partially offset by:

• purchases of investment securities totaling $101.3 million and

• repayment of FHLB advances totaling $15.3 million.

We use our sources of funds primarily to meet our ongoing commitments, fund loan commitments, fund maturing certificates of deposit and savings withdrawals, and maintain an investment securities portfolio.  We anticipate that we will continue to have sufficient funds to meet our current commitments.

Our liquidity needs consist primarily of operating expenses and dividend payments to shareholders.  The primary sources of liquidity are cash and cash equivalents and dividends from the Bank.  We are prohibited

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from repurchasing shares and incurring any debt at the parent company without the prior approval of the Office of the Comptroller of the Currency (the OCC) under our informal regulatory agreement.

We are currently prohibited from paying dividends without the prior approval of the OCC pursuant to our informal regulatory agreement.  Absent such restriction, regulations provide various standards under which the Bank may declare and pay dividends to the Company without prior approval.   The dividends from the Bank are limited to the extent of the Bank’s cumulative earnings for the year plus the net earnings (adjusted by prior distributions) of the prior two calendar years.  At September 30, 2011, under current regulations, the Bank had $7.1 million of retained earnings available for dividend declarations.  At September 30, 2011, the parent company had $2.7 million in cash and cash equivalents.  We do not anticipate that these restrictions will have a material adverse impact on our liquidity in the short-term.

Contractual Obligations

The following table presents our contractual obligations to third parties at September 30, 2011 by maturity:

	Payments Due By Period
			Over One		Over Three		Over
	One Year		through		through		Five
	or less		Three Years		Five Years		Years		Total
	(Dollars in thousands)
Certificates of deposit	$	280,051	$	88,766	$	20,126	$	731	$	389,674
FHLB advances (1)		351		16,750		15,815		7,024		39,940
Short-term borrowed funds (2)		16,175	—		—		—			16,175
Service bureau contract		1,666		3,332		3,332	—			8,330
Operating leases		401		556		268		1,902		3,127
Dividends payable on common stock		109	—		—		—			109
	$	298,753	$	109,404	$	39,541	$	9,657	$	457,355

           ______________

           (1)   Does not include interest expense at the weighted-average contractual rate of 2.90% for the periods presented.

           (2)   Does not include interest expense at the weighted-average contractual rate of .30% for the periods presented.

See the “Borrowed Funds” section for further discussion surrounding FHLB advances.  The operating lease obligations reflected above include the future minimum rental payments, by year, required under the lease terms for premises and equipment.  Many of these leases contain renewal options, and certain leases provide options to purchase the leased property during or at the expiration of the lease period at specific prices.

Off-Balance Sheet Obligations

We are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our clients.  These financial instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the statement of condition.  Our exposure to credit loss in the event of non-performance by the third-party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual notional amount of those instruments.  We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments.

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The following table details the amounts and expected maturities of significant commitments at September 30, 2011:

			Over One		Over Three		Over
	One Year		through		through		Five
	or Less		Three Years		Five Years		Years		Total
	(Dollars in thousands)
Commitments to extend credit:
Commercial and industrial	$	17,659	$	—	$	—	$	85	$	17,744
Commercial real estate:
Owner occupied		6,038		—		135		—		6,173
Non-owner occupied		—		—		—		—		—
Multifamily		240		—		—		—		240
Commercial construction and land development		2,268		—		—		—		2,268
Commercial participations		—		48		—		—		48
Retail		6,856		—		—		—		6,856
Commitments to fund unused:
Equity lines of credit		15,976		—		—		40,356		56,332
Commercial business lines		54,064		7,197		150		100		61,511
Construction loans		2,303		—		2,908		—		5,211
Credit enhancements		3,893		—		4,307		9,225		17,425
Letters of credit		3,282		250		—		—		3,532
	$	112,579	$	7,495	$	7,500	$	49,766	$	177,340

   The commitments listed above do not necessarily represent future cash requirements, in that these commitments often expire without being drawn upon.  Credit enhancements expire at various dates through 2018.  Letters of credit expire at various dates through 2013.

We also have commitments to fund community investments through investments in various limited partnerships, which represent future cash outlays for the construction and development of properties for low-income housing, small business real estate, and historic tax credit projects that qualify under the Community Reinvestment Act.  These commitments include $384,000 to be funded over three years.  The timing and amounts of these commitments are projected based upon the financing arrangements provided in each project’s partnership agreement, and could change due to variances in the construction schedule, project revisions, or the cancellation of the project.  These commitments are not included in the commitment table above.

Credit enhancements are related to the issuance by municipalities of taxable and nontaxable revenue bonds.  The proceeds from the sale of such bonds are loaned to for-profit and not-for-profit companies for economic development projects.  In order for the bonds to receive AAA ratings, which provide for a lower interest rate, the FHLB issues, in favor of the bond trustee, an Irrevocable Direct Pay Letter of Credit (IDPLOC) for our account.  Since we, in accordance with the terms and conditions of a Reimbursement Agreement between the FHLB, would be required to reimburse the FHLB for draws against the IDPLOC, these facilities are analyzed, appraised, secured by real estate mortgages, and monitored as if we had funded the project initially.

Regulatory Capital  

The Bank is subject to minimum capital adequacy guidelines as set forth in regulations previously adopted by the Office of Thrift Supervision (OTS) which are now enforced by the OCC.  Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators, which could have a material impact on the Bank’s financial statements.  Under capital adequacy

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guidelines and the regulatory framework for prompt corrective action, the Bank must maintain capital amounts in excess of specified minimum ratios based on quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices.

Quantitative measures previously established by the OTS to ensure capital adequacy require us to maintain minimum amounts and ratios (as set forth in the table below) of three capital requirements: tangible capital (as defined in the regulations) as a percentage of adjusted total assets, core capital (as defined) as a percentage of adjusted total assets, and risk-based capital (as defined) as a percentage of total risk-weighted assets.  At September 30, 2011, the Bank exceeded all minimum regulatory capital ratios to be considered “well capitalized.”

The Bank’s actual capital amounts and ratios, as well as minimum amounts and ratios required for capital adequacy and prompt corrective action provisions are presented in the following table:

											To Be Well Capitalized
						For Capital Adequacy					Under Prompt Corrective
	Actual					Purposes					Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
As of September 30, 2011:
Tangible capital to adjusted total assets	$	102,944		8.87	%	$	17,414		>=1.5	%	$	23,218		>=2.0	%
Tier 1 (core) capital to adjusted total assets		102,944		8.87			46,437		>=4.0			58,046		>=5.0
Tier 1 (core) capital to risk-weighted assets		102,944		12.31			33,449		>=4.0			50,174		>=6.0
Total capital to risk-weighted assets		113,480		13.57			66,899		>=8.0			83,623		>=10.0
As of December 31, 2010:
Tangible capital to adjusted total assets	$	101,144		9.07	%	$	16,719		>=1.5	%	$	22,292		>=2.0	%
Tier 1 (core) capital to adjusted total assets		101,144		9.07			44,583		>=4.0			55,729		>=5.0
Tier 1 (core) capital to risk-weighted assets		101,144		12.26			33,005		>=4.0			49,508		>=6.0
Total capital to risk-weighted assets		109,869		13.32			66,011		>=8.0			82,514		>=10.0

As of September 30, 2011 and December 31, 2010, the Bank was categorized as “well capitalized” under the regulatory framework for prompt corrective action.  To be categorized as “well capitalized,” the Bank must maintain a minimum core capital to adjusted total assets, core capital to risk-weighted assets, and total capital to risk-weighted asset ratios as set forth in the table above.

The following table reflects the adjustments required to reconcile the Bank’s shareholders’ equity to the Bank’s regulatory capital at September 30, 2011:

	Tangible			Core			Risk-Based
	(Dollars in thousands)
Shareholders’ equity of the Bank	$	113,326		$	113,326		$	113,326
Disallowed deferred tax asset		(12,645	)		(12,645	)		(12,645	)
Adjustment for unrealized losses on certain available-for-sale securities		3,104			3,104			3,104
Other		(841	)		(841	)		(841	)
General allowance for loan losses		—			—			10,536
Regulatory capital of the Bank	$	102,944		$	102,944		$	113,480

The increase in the Bank’s risk-based capital ratio from December 31, 2010 is primarily a result of an increase in the Bank’s shareholders’ equity from net income for 2011 coupled with an increase in other interest

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earning deposits that are in the 0% risk-weighting category.  In addition, the Bank reclassified its ASC 310-10 allowance on impaired loans into the general allowance for loan losses for regulatory reporting and risk-based capital calculation purposes.  In 2010, the Office of Thrift Supervision indicated that these reserves on non-collateral dependent loans should be classified as specific valuation allowances which would require that the ASC 310-10 allowance for non-collateral dependent impaired loans reduce the balance of loan receivables for regulatory reporting purposes and the allowance for loan losses which reduced the Bank’s total loans receivable, risk-based assets and the amount of risk-based capital.  Upon transition to the OCC as the Bank’s regulatory agency, the OCC has clarified that the ASC 310-10 allowance for non-collateral dependent impaired loans should be considered as part of the general allowance for loan losses for regulatory reporting purposes.  This change was made for the Bank’s regulatory report for the third quarter of 2011 and increased the Bank’s risk-based capital ratio by 21 basis points.

Determining the amount of deferred tax assets included or excluded in periodic regulatory capital calculations requires significant judgment when assessing a number of factors.  In assessing the amount of the disallowed deferred tax asset, we consider a number of relevant factors including the amount of deferred tax assets dependent on future taxable income, the amount of taxes that could be recovered through loss carrybacks, the reversal of temporary book tax differences, projected future taxable income within one year, available tax planning strategies, and OCC limitations.  Using all information available to us at each statement of condition date, these factors are reviewed and vary from period to period.

Item 3.          Quantitative and Qualitative Disclosures about Market Risk

Our primary market risk is considered to be interest rate risk.  Interest rate risk on our balance sheet arises from the maturity mismatch of interest-earning assets versus interest-bearing liabilities, as well as the potential for maturities to shorten or lengthen on our interest-earning assets, and to a lesser extent on our interest-bearing liabilities due to the exercise of options.  The most common of these are prepayment options on mortgage loans, and commercial mortgage-backed securities, and to a lesser extent jump-rate features in certain of our certificates of deposit.  Management’s goal, through policies established by the Asset/Liability Management Committee of the Board of Directors (ALCO), is to maximize net interest income while achieving adequate returns on equity capital and managing our balance sheet within the established interest rate risk policy limits prescribed by the ALCO.

We maintain a written Asset/Liability Management Policy that establishes written guidelines for the asset/liability management function, including the management of net interest margin, interest rate risk (IRR), and liquidity.  The Asset/Liability Management Policy falls under the authority of the Board of Directors which in turn assigns its formulation, revision, and administration to the ALCO.  The ALCO schedules monthly meetings and consists of certain senior officers and one outside director.  The results of the meetings are reported to the Board of Directors.  The primary duties of the ALCO are to develop reports and establish procedures to measure and monitor IRR, verify compliance with Board approved IRR tolerance limits, take appropriate actions to mitigate those risks, monitor and discuss the status and results of implemented strategies and tactics, monitor our capital position, review the current and prospective liquidity positions, and monitor alternative funding sources.  The policy requires management to measure overall IRR exposure using Net Present Value analysis and earnings-at-risk analysis.

 We use Net Portfolio Value Analysis as the primary measurement of our interest rate risk.  Under prior OTS regulations in Thrift Bulletin 13a, we are required to measure our interest rate risk assuming various increases and decreases in general interest rates and their effect on our market value of portfolio equity.  The Board of Directors has established limits to changes in Net Portfolio Value (NPV), (including limits regarding

64

the change in net interest income discussed below), across a range of hypothetical interest rate changes.  If estimated changes to NPV and net interest income are not within these limits, the Board may direct management to adjust its asset/liability mix to bring its interest rate risk within Board limits.  NPV is computed as the difference between the market value of assets and the market value of liabilities, adjusted for the value of off-balance sheet items.

Net Portfolio Value Analysis measures our interest rate risk by calculating the estimated change in NPV of our cash flows from interest-sensitive assets and liabilities, as well as certain off-balance sheet items, in the event of a shock in interest rates ranging down 200 to up 300 basis points.  The following table shows the change in NPV applying the various instantaneous rate shocks to the Bank’s interest-earning assets and interest-bearing liabilities as of September 30, 2011 and December 31, 2010.

	Net Portfolio Value
	At September 30, 2011								At December 31, 2010
	$ Amount		$ Change			% Change			$ Amount		$ Change			% Change
	(Dollars in thousands)
Assumed Change in Interest Rates
(Basis Points)
+300	$	136,508	$	16,166			13.4	%	$	135,273	$	5,530			4.3	%
+200		134,233		13,891			11.5			135,380		5,637			4.3
+100		129,254		8,912			7.4			132,500		2,757			2.1
0		120,342		—			—			129,743		—			—
-100		106,526		(13,816	)		(11.5	)		119,664		(10,079	)		(7.8	)
-200		100,561		(19,781	)		(16.4	)		111,927		(17,816	)		(13.7	)

Our reported earnings at risk analysis models the impact of instantaneous parallel shifts in yield curve changes in interest rates (assuming interest rates rise and fall in increments of 100 basis points), on anticipated net interest income over a twelve month horizon.  These models are modeling underlying cash flows in each of our interest-sensitive portfolios under these changing rate environments.  This includes adjusting anticipated prepayments, changing expected business volumes and mix as well as modeling anticipated changes in interest rates paid on core deposit accounts, whose rates do not necessarily move in any relationship to movements in Treasury rates.  We compare these results to our results assuming flat interest rates.

The following table presents the projected changes in net interest income over a twelve month period for the various interest rate change (rate shocks) scenarios at September 30, 2011 and December 31, 2010, respectively.

	Change in
	Net Interest Income
	Over a Twelve
	Month Period
	September 30, 2011					December 31, 2010
	$ Change		% Change			$ Change			% Change
Assumed Change in Interest Rates
(Basis Points)
+300	$	1,997		5.5	%	$	(504	)		(1.3	)%
+200		1,291		3.6			(334	)		(.9	)
+100		582		1.6			(231	)		(.6	)
-100		192		0.5			1,276			3.4
-200		33		0.1			808			2.2

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The table above indicates that if interest rates were to move up 200 basis points, net interest income would be expected to increase 3.6% in year one; and if interest rates were to move down 100 basis points, net interest income would be expected to increase .5% in year one.  Interest income projections for rates moving down 100 basis points are greater than for rates moving down 200 basis points as rates on short-term liabilities have limited room to reprice lower while rates on certain assets are at contractual or absolute floors.  The primary causes for the changes in net interest income over the twelve month period were a result of the changes in the composition of interest earning assets and interest-bearing liabilities, their repricing characteristics and frequencies, and related interest rates.  The net interest income projections for rising rates have improved since December 31, 2010 as the Bank has been growing low-cost core deposits, extending the maturities on fixed-rate borrowing liabilities, shifting the investment securities portfolio from fixed-rate bonds to floating-rate bonds, and growing interest-earning bank deposit assets.  Actual results will differ from the above model results due to timing, magnitude and frequency of interest rate changes, as well as changes in market conditions and management strategies.  The above table does not reflect any actions we might take in response to changes in interest rates.

We manage our IRR position by holding assets with various desired IRR characteristics, implementing certain pricing strategies for loans and deposits, and implementing various investment securities portfolio strategies.  On a quarterly basis, the ALCO reviews the calculations of all IRR measures for compliance with the Board approved tolerance limits.  At September 30, 2011, we were in compliance with all of our tolerance limits with the exception of the NPV tolerance limit for a movement in rates down 200 basis points.  Given the current low level of interest rates, we do not believe this exception is material because this interest scenario is not probable.

The IRR analyses include the assets and liabilities of the Bank only.  Inclusion of Company-only assets and liabilities would not have a material impact on the results presented.

Item 4.        Controls and Procedures

No change in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) under the Securities Exchange Act of 1934, as amended) occurred during the quarter ended September 30, 2011 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Management evaluated, with the participation of the Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) or 15(d)-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report.  Based on such evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and regulations and are operating in an effective manner as of such date.

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Part II.         OTHER INFORMATION

Item 1.          Legal Proceedings

The Company is involved in routine legal proceedings occurring in the ordinary course of business, which, in the aggregate, are believed to be immaterial to the financial condition, results of operations, and cash flows of the Company.

Item 1A.       Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in “Item 1A. Risk Factors” contained in our Annual Report on Form 10-K for the year ended December 31, 2010 (the 2010 Form 10-K), as updated in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2011 (the Form 10-Q), which could materially affect our business, financial condition, or future results.  There have been no material changes from the risk factors as disclosed in the 2010 Form 10-K and the Form 10-Q.

Item 2.          Unregistered Sales of Equity Securities and Use of Proceeds

(a)	Not applicable.
(b)	Not applicable.
(c)	We did not repurchase any shares of our common stock during the quarter ended September 30, 2011.  Under our repurchase plan publicly announced on March 20, 2008 for 530,000 shares, we have 448,612 shares that may yet be purchased.  We are currently prohibited from repurchasing our common stock without prior approval pursuant to an informal regulatory agreement.

Item 3.          Defaults Upon Senior Securities

(a)	None.
(b)	Not applicable.

Item 4.          (Removed and Reserved)

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Item 5.           Other Information

(a)	Not applicable.
(b)	None.

Item 6.           Exhibits

(a)	List of exhibits (filed herewith unless otherwise noted).
3.1	Articles of Incorporation of CFS Bancorp, Inc. (1)
3.2	Amended and Restated Bylaws of CFS Bancorp, Inc. (2)
4.0	Form of Stock Certificate of CFS Bancorp, Inc. (3)
31.1	Rule 13a-14(a) Certification of Chief Executive Officer
31.2	Rule 13a-14(a) Certification of Chief Financial Officer
32.0	Section 1350 Certifications
101.0	The following financial statements from the CFS Bancorp, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 2011, filed on November 2, 2011, formatted in Extensive Business Reporting Language (XBRL):  (i) condensed consolidated statements of condition, (ii) condensed consolidated statements of income, (iii) condensed consolidated statements of changes in shareholders’ equity, (iv) condensed consolidated statements of cash flows, and (v) the notes to condensed consolidated financial statements (4)

____________

         (1) Incorporated herein by Reference to the Company’s Definitive Proxy Statement from the Annual Meeting of Shareholders filed with the SEC on March 25, 2005 (File No. 000-24611).

         (2) Incorporated herein by Reference to the Company’s Form 8-K filed with the SEC on December 17, 2010.

         (3) Incorporated herein by Reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 filed with the SEC on March 15, 2007.

         (4) As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1033 and Section 18 of the Securities Exchange Act of 1934.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

CFS BANCORP, INC.

Date:  November 2, 2011	By:	/s/ Thomas F. Prisby
		Thomas F. Prisby, Chairman of the Board and
		Chief Executive Officer
Date:  November 2, 2011	By:	/s/ Jerry A. Weberling
		Jerry A. Weberling, Executive Vice President
		and Chief Financial Officer

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